THE 

ARTHUR  YOUNG 

ACCOUNTING 

COLLECTION 


Graduate  School  of 
Business  Administration 

Library  of  the 

University  of  California 

Los  Angeles 


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'ALIFORNIA 


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Graduate  School  of  Business  Administration 

Un:         '       !       -"  California 

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MODERN   ACCOUNTING 


MODERN 
ACCOUNTING 

ITS   PRINCIPLES   AND   SOME 
OF  ITS   PROBLEMS 


BY 


HENRY  RAND   HATFIELD,  PH.B. 

PEOFESSOK  OF  ACCOUNTING 
UNIVEBSITY  OF  CALIFOBNIA 


NEW  YORK   AND   LONDON 

D.  APPLETON   AND   COMPANY 
1920 


82923 


COPYRIGHT,  1909,  BY 
D.  APPLETON  AND  COMPANY 


PRINTED  IN  THE  UNITED  STATES  OF  AMERICA 


Bus.  Admin. 

Library 


HF 
5625 

PREFACE  [|2jT 


IN  the  following  treatise  an  attempt  is  made  to  present 
tho  principles  of  accounting.  In  doing  so  the  details  of 
technic,  important  though  they  are,  are  purposely  omitted 
or  treated  with  the  scantest  mention.  The  essence  of  ac- 
counting, from  the  author's  view  point,  is  the  presentation, 
first,  of  a  correct  exhibit  of  the  financial  status  of  the  con- 
cern at  a  given  moment  of  time,  and,  secondly,  a  showing 
of  the  results  obtained  during  a  given  period  of  time.  The 
first  is  embodied  in  the  Balance  Sheet;  the  second  in  the 
Income  or  Profit  and  Loss  statement. 

In  the  ordinary  routine  of  the  accountant's  toil  there 
is,  indeed,  another  function;  that  of  keeping  account  of 
claims  and  property,  in  order  to  secure  the  concern  against 
the  loss  which  might  arise  from  forgetfulness,  carelessness 
or  dishonesty.  This  phase  of  accounting  attains  its  acme 
in  governmental  accounting  where  the  essential  thing  is  to 
insure  the  proper  handling  of  vast  sums.  But  this  seems  a 
matter  of  much  less  scientific  interest  and  is  not  treated 
in  this  work. 

The  method  of  treatment,  in  general,  has  therefore  been 
to  consider  how  a  given  transaction  is  made  manifest  in 
the  Balance  Sheet,  the  goal  which  the  accountant  ever  has 
in  mind.  The  technical  entries  to  be  made  in  the  journal 
or  in  other  books  of  original  entry  are  excluded.  They  are 
not  of,  such  importance  for  the  forms  in  which  such  entries 
are  made  vary  according  to  the  needs  of  the  office  economy, 


vi  PREFACE 

and  still  more  because  they  are  only  the  steps  by  which  the 
Balance  Sheet  is  formed.  Keeping  the  latter  constantly 
in  mind,  serves  to  make  clear  the  logical  significance  of 
each  transaction  recorded.  That  being  clear  the  technical 
entry  to  be  made  is  an  obvious  matter. 

The  presentation  of  a  correct  view  of  the  concern's 
financial  status  and  of  its  past  profits  involves  many 
points  of  theoretical  interest  and  of  practical  importance. 
To  present  an  intelligible  view  it  is  essential  to  have  a 
rather  definitely  crystallized  terminology  so  that  the  terms 
used  with  a  technical  meaning  shall  be  definitely  under- 
stood with  the  exact  connotation  intended.  Unfortunately, 
despite  the  advancement  made  in  accounting  practice, 
there  is  a  most  embarrassing  confusion  in  terminology,  so 
that  one  can  never  be  sure  of  just  what  is  meant  by  a 
given  account.  Amperes  and  ohms,  miners  inches  and 
foot  pounds,  have  definite  meanings  free  from  misunder- 
standing. But  the  current  terms  of  accounting :  Reserves, 
Depreciation  Fund,  Manufacturing  Costs,  even  Profits,  are 
loosely  and  divergently  used.  More  serious  still  is  the 
uncertainty  as  to  the  correct  principle  to  follow  in  many 
cases,  as  for  instance  in  the  valuation  of  fixed  assets  and 
the  method  of  estimating  depreciation. 

In  some  cases  it  is  possible  to  differentiate  certain 
usages  as  bad,  some  methods  as  involving  incorrect  prin- 
ciples. But  this  is  not  always  true  and  when  in  doubt 
there  is  no  ultimate  arbiter  to  whom  appeal  can  confidently 
be  made.  In  this  dilemma  it  has,  therefore,  seemed  advis- 
able to  show  the  existing  variations  rather  than  to  attempt 
to  formulate  rigid  rules.  The  comparative  study  of  ac- 
counting practice  will,  perhaps,  be  a  greater  service  to 


PKEFACE  vii 

accounting  science  than  a  more  dogmatic  treatise.  Refer- 
ence has  accordingly  been  frequently  made  to  the  pub- 
lished accounts  of  corporations  which  presumably  exhibit 
current  usage,  and  to  the  leading  English  and  American 
texts.  But  in  addition  considerable  recourse  has  been  had 
to  other  less  obvious  sources  of  information.  These  include 
the  decisions  of  English  and  American  courts,  the  com- 
mercial codes  of  Germany,  France  and  Austria  and  the 
commentaries  of  the  leading  jurists  of  these  countries. 
The  legal  provisions  of  the  Continental  countries  are,  of 
course,  not  binding  on  American  practice.  But  they  are 
of  considerable  significance  in  discussing  the  principles  of 
accounting,  for  they  embody  the  'carefully  expressed  opin- 
ion of  experts  on  many  difficult  problems. 

Such  attention  to  foreign  authorities  is  all  the  more 
necessary  since  in  this  country  far  too  little  attention  has 
been  given  to  matters  of  principle.  American  accounting 
is  famed  for  short  cuts  and  practical  efficiency.  At  the 
same  time  the  accounts  of  American  corporations,  until 
Very  recent  years,  have  been  replete  with  questionable 
practices,  oftentimes  vicious  in  principle  and  misleading  in 
their  results. 

While  the  work  is  mainly  a  discussion  of  the  problems 
of  practical  accounting,  it  has  seemed  advisable  to  insert 
an  introductory  section  on  the  theory  of  double  entry  book- 
keeping. Those  who  are  familiar  with  the  literature  of  the 
subject  need  not  be  told  of  the  author's  indebtedness  to 
J.  F.  Schaer  whose  clear  writings  have  done  much  to  put 
bookkeeping  on  a  more  rational  basis.  Of  especial  value 
has  been  that  writer's:  "  Versuch  einer  wissenschaftlichen 
Behandlung  der  Buchhaltung. " 


viii  PKEFACE 

The  twofold  classification  of  accounts  herein  adopted 
differs  materially  from  the  customary  treatment  in  Ameri- 
can text-books.  The  conventional  division  of  accounts  into 
real,  personal  and  fictitious,  as  Jones  pointed  out  in  1841, 
* '  renders  all  theorizing  impossible,  and v  shuts  up  every 
avenue  to  the  more  general  principles  of  the  subject  on 
which  the  analysis  of  accounts  so  immediately  depends." 
So  too  there  is  a  marked  divergence  in  the  treatment  of 
the  terms  Debit  and  Credit,  the  mere  rules  of  thumb  so 
generally  used  being  abandoned  for  what,  it  is  hoped,  is 
not  only  more  rational  but  actually  of  greater  practical 
value  to  the  student  wrestling  with  the  problems  of  ele- 
mentary bookkeeping. 

HENRY  RAND  HATFIELD. 


CONTENTS 


CHAPTER  I 
THE   PRINCIPLES   OF   DOUBLE   ENTRY   BOOKKEEPING 

PAGES 

The  Fundamental  Equation  of  Bookkeeping — Goods — Pro- 
prietorship— Exchange,  Profit  and  Loss,  and  Mixed  Trans- 
actions— The  Development  of  a  System  of  Accounts — 
The  Classification  of  Goods  Accounts — The  Classification 
of  Proprietorship  Accounts — The  Purpose  of  the  Double 
Set  of  Accounts — Mixed  Accounts — The  Introduction  of  the 
Inventory — Debts  or  Negative  Goods — Summary  of  Prin- 
ciples   1-15 

CHAPTER  II 
THE  PRINCIPLES   OF   DOUBLE   ENTRY  BOOKKEEPING   (Continued) 

The  Ledger — Debit  and  Credit — The  Clearing  of  Mixed  Accounts 
— Negative  Accounts — The  Balance  of  Accounts — Imper- 
fections in  Double  Entry  Bookkeeping — Bibliographical 
Note  to  Chapters  I  and  II 16-34 

CHAPTER  III 
THE   BALANCE   SHEET 

The  Trial  Balance — The  Formation  of  the  Balance  Sheet — The 
Two  Sides  of  the  Balance  Sheet:  (1)  The  English  Inverted 
Order;  (2)  Variations  in  Headings — The  Grouping  and 
Marshaling  of  Items — The  Double-Account  Balance  Sheet 
— Valuation  Accounts  in  the  Balance  Sheet — The  Balance 
Sheet  in  Relation  to  Profits — Accuracy  in  the  Balance 
Sheet — Examples  of  the  Balance  Sheets  of  Corporations 
— Bibliographical  Note 35-69 


x  CONTENTS 

CHAPTER  IV 

ASSETS   AND   THE   PRINCIPLES   OF  VALUATION 

The  Difficulty  in  Distinguishing  Assets  from  Expense  Items — 
Revenue  Expenditure  and  Capital  Expenditure — The 
Problems  of  the  Inventory:  (1)  What  Items  are  to  be  In- 
cluded? (2)  What  is  the  Cost  Price?  (3)  What  is  the 
Basis  for  Revaluation? — Undervaluation  in  the  Inventory 
— Bibliographical  Note 70-85 

CHAPTER    V 

THE   VALUATION   OF  PARTICULAR   ASSETS 

Land:  (1)  Permanent  Holdings  Valued  at  Cost;  (2)  Land  Held 
as  Merchandise — Buildings — Machinery,  Tools,  etc. — In- 
vestments: (1)  The  Significance  of  Public  Quotations;  (2) 
The  Market  Price  Logically  Negligible  for  Permanent  In- 
vestments; (3)  Legal  Regulations  Regarding  Valuation; 
(4)  Value  as  Affected  by  Time — Mercantile  Credits — Mer- 
chandise: (1)  Cost  the  Normal  Basis  for  Appraisal ;  (2)  Prob- 
lems in  Determining  Cost — Bibliographical  Note  .  .  86-106 

CHAPTER  VI 
IMMATERIAL  ASSETS 

Goodwill:  (1)  Legitimacy  of  Including  Goodwill  Among  Assets; 
(2)  Value  Limited  to  Actual  Cost;  (3)  The  Purchase  of 
Fictitious  Goodwill;  (4)  Factors  Determining  the  Value 
of  Goodwill;  (5)  The  Rate  of  Capitalization;  (6)  The 
Writing-off  of  Goodwill — Deferred  Assets:  (1)  Definition; 
(2)  The  Writing-off  of  Deferred  Assets;  (3)  Losses  Appear- 
ing among  Deferred  Assets — Bibliographical  Note  .  .  107-120 

CHAPTER  VII 

DEPRECIATION 

The  Economic  Significance  of  Depreciation — Depreciation  and 
Anticipation  Accounts — Depreciation  and  Profits — De- 
preciation in  the  Courts — The  Rulings  of  the  Interstate 
Commerce  Commission — Methods  of  Booking  Deprecia- 


CONTENTS  xi 

tion — Methods  of  Estimating  Depreciation:  (1)  Percentage 
of  Original  Cost;  (2)  Percentage  of  Diminishing  Value;  (3) 
Annuity  Method;  (4)  Comparison  of  Above  Methods — De- 
preciation in  Relation  to  the  Total  Cost  of  Production — 
Irregular  Charges  to  Depreciation — Excessive  Depreciation 
• — Depreciation  and  Replacement — Depreciation  for  Other 
than  Wear  and  Tear — Specific  Rates  Charged — Bibliograph- 
ical Note 121-143 

CHAPTER  VIII 

CAPITAL  STOCK.     I.     ISSUED   FOR   CASH 

The  Capital  Account  of  Individual  Traders — The  Different 
Treatment  of  Capital  in  Corporation  Accounts — Subscrip- 
tions to  Capital  Stock:  (1)  Subscription  Implies  Payment  in 
Full;  (2)  Unsubscribed  and  Treasury  Stock;  (3)  Uncalled 
Subscriptions ;  (4)  Subscriptions  at  a  Premium — The  Sale  of 
Capital  Stock:  (1)  Discussion  of  Decision  in  Handley  v. 
Stutz;  (2)  Proper  Booking  of  Stock  Sold  Below  Par — The 
Reduction  of  Capital  Stock 144-160 

CHAPTER  IX 

'  • 

CAPITAL   STOCK.     II.     ISSUED   FOR  PROPERTY,   ETC. 

Distinction  between  Issues  for  Property  and  for  Cash — Stock 
Issued  for  Less  than  Par:  (1)  The  Legal  Distinction  between 
Par  and  Market  Value;  (2)  The  Issue  of  Stock  at  "Market 
Value";  (3)  The  Proper  Accounting  for  Such  Issues;  (4) 
Subterfuges  Found  in  Accounts — Stock  Watering — Stock 
Dividends — Donation  of  Stock  to  the  Company — The  Use  of 
the  Term  "Working  Capital" — Stock  Issued  to  Combine 
Corporations — Bibliographical  Note  to  Chapters  VIII  and 
IX 161-183 

CHAPTER  X 
LIABILITIES 

Liabilities  as  Negative  Goods — Accounting  Problems:  (l)The 
Classification  of  Liabilities;  (2)  Interest  Adjustments;  (3)  Un- 
issued Bonds;  (4$» Repurchased  and  Treasury  Bonds;  (5) 
Uncertain  Liabilities — Bibliographical  Note  .  .  •.  184-194 


xii  CONTENTS 

CHAPTER  XI 

PROFITS 

PAGES 

The  Profit  and  Loss  Account:  (1)  Definition;  (2)  Purpose;  (3) 
Relation  to  Other  Accounts — Charging  Losses  to  the  Profit 
and  Loss  Account:  (1)  The  Exploitation  of  "Wasting 
Assets";  (2)  The  Loss  of  "Fixed  Capital";  (3)  The  Relation 
of  Previous  Losses  to  Current  Profits;  (4)  Decisions  in 
American  Courts 195-213 

CHAPTER  XII 

PROFITS   (Continued) 

The  Relation  of  Capital  Losses  to  Dividends:  (1)  The  Legality  of 
Paying  Dividends  when  there  has  been  a  Capital  Loss; 
(2)  The  Business  Policy  of  Such  Dividends;  (3)  The  Proper 
Booking  of  Capital  Losses — The  Credit  Side  of  the  Profit  and 
Loss  Account:  (1)  Premium  on  Stocks  and  Bonds;  (2)  Appre- 
ciation of  "Capital  Assets";  (3)  Unrealized  Profits;  (4)  The 
Doctrine  that  Profits  Must  Consist  of  Cash  Receipts — Legal 
Decisions  Concerning  the  Relation  between  Profits  and  Un- 
paid Debts — The  Payment  of  Dividends  out  of  Borrowed 
Funds — Summary  of  the  Attitude  of  the  Courts  in  Regard 
to  Profits — Bibliographical  Note  to  Chapters  XI  and  XII  214-232 

CHAPTER  XIII 
SURPLUS   AND   RESERVES 

The  Nature  of  a  Surplus — Surplus  to  be  Distinguished  from 
Valuation  Accounts:  Illustration  and  Definition  of  Terms 
Used — Purposes  for  which  Surplus  Established:  (1)  To 
Provide  Additional  Permanent  Capital;  (2)  To  Provide  for 
Emergencies;  (3)  To  Equalize  Dividends — General  and 
Special  Reserves — Criticism  of  Claim  that  Reserves  must 
be  Specially  Covered:  (1)  Confuses  Two  Sides  of  Balance 
Sheet;  (2)  A  Specially  Covered  Reserve  no  more  Secure  or 
Available;  (3)  Leads  to  False  Financial  Theories;  (4)  Cita- 
tion of  Authorities — Reserves  and  Reserve  Funds — Re- 
serves in  Banking  and  in  Insurance — Secret  Reserves — 
The  Application  of  a  Reserve:  (1)  To  Cover  Losses,  etc. ;  (2) 
,  To  Make  Extensions,  etc. — Reserve  for  Insurance — Biblio- 
graphical Note  .  . 233-260 


CONTENTS  xiii 

CHAPTER  XIV 

SINKING   FUNDS 

PAGES 

Definition — The  Four  Methods  of  Booking  a  Sinking  Fund — 
Sinking  Fund  Installments  in  Relation  to  Income — Interest 
on  Sinking  Fund  Investments — The  Payment  of  Bonds  from 
the  Sinking  Fund — The  Calculation  of  Amount  Necessary 
for  Sinking  Fund — Sinking  Funds  and  Depreciation — 
Bibliographical  Note 261-273 

CHAPTER  XV 
TRADING,   MANUFACTURING,   AND   INCOME   ACCOUNTS 

The  Purpose  of  Subdividing  the  Profit  and  Loss  Account — Types 
of  Such  Accounts:  (1)  The  Trading  Account;  (2)  The  Manu- 
facturing Account;  (3)  The  Income  Account  of  Railroads — 
The  General  Principle  Involved  in  thtf  Form  of  Such  Ac- 
counts— Problems  Relating  to  Such  Accounts:  (1)  The 
Valuation  of  Manufactured  Goods;  (2)  The  Items  to  be 
Included  in  the  Trading  Section;  (3)  The  Determination  of 
Selling  Price ;  (4)  The  Treatment  of  Taxes ;  (5)  Depreciation 
— Bibliographical  Note 274-292 

CHAPTER  XVI 
COST  ACCOUNTS 

The  Purpose  of  Cost  Accounting — Different  Conceptions  of 
Cost — The  Elements  of  Cost:  (1)  Direct  or  Prime  Cost;  (2) 
Indirect  Factory  Expenses;  (3)  General  Establishment 
Charges — General  Problems  in  Applying  Cost  Accounting: 
(1)  Expense  of  the  System;  (2)  Accuracy  to  be  Obtained;  (3) 
The  Use  to  be  Made  of  Cost  Estimates — The  Technic  of  Cost 
Accounting — Bibliographical  Note 293-315 

CHAPTER  XVII 

PARTNERSHIP   ACCOUNTS 

The  Establishment  of  the  Partnership:  (1)  The  Amount  Con- 
tributed; (2)  A  Share  of  the  Profits  and  a  Share  in  the  Busi- 
ness; (3)  Contributing  a  Share  and  Buying  a  Share — Inter- 
est on  the  Partners'  Capital:  (1)  On  Total  Contribution; 


xiv  CONTENTS 

PAGES 

(2)  On  Excess  or  Deficit — Liquidation:  (1)  The  Appor- 
tioning of  Assets  in  Liquidation;  (2)  Distribution  of  Assets 
in  Installments — Bibliographical  Note  ....  316-334 

CHAPTER  XVIII 
THE  STATEMENT  OF  AFFAIRS  AND   DEFICIENCY  ACCOUNT 

The  Use  of  the  Statement  of  Affairs  and  Deficiency  Account — 

Discussion  of  Variations  in  Forms — Bibliographical  Note  335-340 

CHAPTER  XIX 

TECHNICAL   IMPROVEMENTS   IN   ACCOUNTING  PRACTICE 

Improvements  in  Relation  between  Chronological  and  Classified 
Records — Improvements  in  the  Form  of  the  Ledger:  (1) 
Method  of  Ruling;  (2)  Abbreviation  of  Entries;  (3)  Cards 
and  Loose  Leaves — Mechanical  Devices  in  Accounting:  (1) 
Adding  Machines;  (2)  Calculating  Machines;  (3)  Tabulating 
Machines — Effect  of  Economic  Changes  on  the  Develop- 
ment of  Accounting:  (1)  The  Factory  System;  (2)  The 
Corporate  Form  of  Industry — Bibliographical  Note  .  341-357 

INDEX  359 


MODERN  ACCOUNTING 


CHAPTER   I 

THE    THEORY   OF   DOUBLE   ENTRY   BOOKKEEPING 

DOUBLE  entry  bookkeeping,  the  basis  of  all  modern 
accounting,  was  first  made  known  to  the  world  in  a  mathe- 
matical treatise  published  in  1494  by  Luca  Paciolo.  This 
work,  the  "  Summa  de  Arithmetica,  Geometria,  Propor- 
tioni  et  Proportionalita, "  not  only  contained  the  first 
printed  work  on  bookkeeping  but  also  included  the  first 
European  treatise  on  Algebra. 

Appropriate  to  this  early  connection  with  algebra, 
double  entry  bookkeeping  starts  out  with  an  equation. 
The  recording  of  all  subsequent  business  transactions  con- 
sists in  altering  the  form  of  the  equation  without  affecting 
the  equality  of  the  two  members.  This  original  equation, 
or  Balance  as  it  is  called  in  the  bookkeeper's  technical  lan- 
guage, when  reduced  to  its  simplest  form  is : 

The  value  of  the  various  Goods  one  owns  =  The  amount 
one  is  worth. 

Or,  to  use  shorter  terms : 

Goods  =  Proprietorship.1 

Goods  is  here  used  in  the  technical  economic  sense  of 
anything,  material  or  otherwise,  to  which  value  attaches. 
The  left-hand  member  of  the  equation  therefore  represents 

1  The  term  Proprietorship,  as  a  collective  term  for  all  the  accounts 
representing  the  "Amount  one  is  worj,h"  is  adopted  from  Charles  E. 
Sprague's  most  valuable  "Philosophy  of  Accounts."  It  is  better  than 
other  terms  which  have  been  used,  as  it  is  free  f r.om  technical  ambiguity. 

1 


2  MODERN   ACCOUNTING 

a  complete  list  or  inventory  of  all  valuable  possessions ;  the 
right-hand  member  expresses  the  total  Proprietorship,  that 
is,  the  capital  or  net  present  worth  of  the  proprietor. 

This  initial  equation  appears  whenever  a  man  first 
starts  a  set  of  books.  It  may  be  illustrated  by  a  new  busi- 
ness in  which  the  proprietor  starts  with  $5,000  cash  on 
hand,  the  equation  here  being : 

Cash  $5,000  =  Proprietorship  $5,000. 

For  the  present,  consideration  of  debts  owed  may  be 
postponed,  and  the  proprietor  may  be .  assumed  to  pay 
cash  on  all  transactions  and  not  to  borrow  any  money. 
With  this  limitation  it  must  be  clear  that  all  possible 
business  transactions,  or  all  possible  operations,  whether 
purchases  or  sales,  the  payment  of  expenses,  the  receipt  of 
rent  or  interest,  the  loss  of  property  by  fire  or  theft,  the 
taking  of  profits  by  the  proprietor,  additional  contributions 
to  or  withdrawals  from  the  original  capital ;  all  operations 
of  any  form  whatever  which  come  under  the  cognizance  of 
the  accountant  may  be  reduced  to  the  following: 

(a)  Operations  in  which  the  kind  of  Goods  owned  is 
altered  by  exchange  of  Goods  of  one  form  for  other  Goods 
of  equal  value ; 

(6)  Operations  in  which  the  amount  (value)  of  Goods 
is  either  increased  or  decreased. 

Furthermore,  it  is  to  be  noted  that  a  business  transac- 
tion may  combine  the  two  changes  so  that  there  is  a  third 
class : 

(c)  Operations  in  which  the  kind  of  Goods  owned  is 
altered  at  the  same  time  that  the  amount  (value)  owned 
is  either  increased  or  decreased. 

These  three  classes  of  operations  may  be  respectively 
called:  (a)  Exchange  or  pure  exchange  transactions,  (6) 
Transactions  affecting  Proprietorship  (or  Profit  and  Loss 
transactions)  and  (c)  Mixed  transactions. 


DOUBLE    ENTRY   BOOKKEEPING  3 

Exchange  transactions  evidently  do  not  alter  the  value 
of  either  member  of  the  original  equation.  If  the  propri- 
etor buys  25  horses  for  $2,500  cash  his  books  no  longer 
show : 

Cash  $5,000  —  Proprietorship  $5,000,  but 

Cash  $2,500  -f  Horses  $2,500  =  Proprietorship  $5,000. 

So  with  any  subsequent  transactions  which  involve  the 
exchange  of  goods  of  equal  value,  it  is  evident  that  there 
can  be  no  change  in  total  value. 

This  may  be  expressed  algebraically :  If  like  values  are 
both  added  to  and  subtracted  from  one  member  of  an 
equation,  the  value  of  the  equation  is  not  altered.  In  this 
case  the  original  equation  takes  the  form 

Cash  $5,000  -f  Horses  $2,500  —  Cash  $2,500  = 
Proprietorship  $5,000. 

Transactions  which  involve  a  pure  exchange  take  place 
whenever  goods  are  purchased  or  whenever  they  are  sold 
at  cost  price :  where  cash  is  deposited  in  the  bank  or  other- 
wise invested;  and  in  debt  transactions  to  be  considered 
later. 

On  the  other  hand,  it  is  true  that  any  transaction  com- 
ing under  &,  changing  as  it  does  the  total  value  of  the 
Goods  owned,  must  be  accompanied  by  an  equivalent  change 
in  the  value  of  the  other  member  of  the  equation.  For 
instance,  if  the  proprietor  in  the  case  mentioned  should 
lose  ten  horses  by  death,  there  would  no  longer  be  the 
equation 

Cash  $2,500  +  Horses  $2,500  =  Capital  $5,000 
for  the  Goods  now  owned  are  Cash  $2,500  -j-  Horses  $1,500 
which  do  not  equal  the  original  Proprietorship  of  $5,000. 

In  order  to  represent  the  correct  position  produced  by 
the  loss  of  the  horses  there  must,  therefore,  be  an  equiva- 
lent change  made  in  the  member  representing  Proprietor- 


4  MODERN   ACCOUNTING 

ship.  The  disappearance  of  the  horses  was  at  the  same 
time  a  diminishment  of  the  amount  the  proprietor  was 
worth.  This  may  be  expressed  algebraically  by  subtract- 
ing from  the  original  equation  another  equation  represent- 
ing the  loss  of  horses,  thus : 

Cash  $2,500  +  Horses  $2,500  =  Proprietorship  $5,000 
Horses     1,000  =  Proprietorship     1,000 

Cash  $2,500  +  Horses  $1,500  —  Proprietorship  $4,000. 

On  the  other  hand,  if  the  proprietor  rents  his  horsea 
receiving  therefor  $100  in  cash  his  statement  will  then 
show  Cash  $2,600  and  $2,500  worth  of  horses.  This  will 
be  correctly  shown  if  to  the  original  equation  is  added  an*, 
other  equation  representing  the  change  produced  by  the 
rent  transaction  thus : 

Cash  $2,500  +  Horses  $2,500  =  Proprietorship  '$5,000 
Cash       100.  =  Proprietorship       100. 

Cash  $2,600  +  Horses  $2,500  =  Proprietorship  $5,100. 

Transactions  which  thus  affect  the  total  value  of  the 
goods  owned,  and  necessitate  a  change  in  Proprietorship 
occur : 

(1)  Whenever  goods  are  surrendered  without  receiving 
an  equivalent  value  in  exchange.    This  occurs  when  there  is 
a  payment  of  expenses  in  distinction  from  a  purchase  of 
goods ;  when  there  is  a  loss,  or  when  there  is  a  withdrawal 
of  cash  or  other  property  by  the  proprietor,  and 

(2)  Conversely  whenever  additional  goods  are  obtained 
without  a  corresponding  exchange,  as  when  clear  profits 
are  received,  or  further  contributions  are  made  by  the  pro- 
prietor.1 

1  The  purchase  of  goods  on  credit  does  not  come  under  this  head  but 
is  an  exchange  transaction.  The  obligation  to  pay  the  debt,  given  to 
the  vendor  is  a  Good  given  in  exchange.  At  present,  however,  only 
rash  transactions  are  considered,  debts  being  discussed  later. 


DOUBLE   ENTEY   BOOKKEEPING 


All  the  principles  of  double  entry  bookkeeping  can  be 
observed  in  an  extremely  simple  set  of  accounts.  This  may 
be  illustrated  by  a  set  in  which  only  the  most  rudimentary 
differentiation  is  made  in  the  Goods,  Cash  being  placed  in 
one  account  in  contradistinction  to  all  other  goods  which 
are  included  in  another  account.  In  such  a  system  the 
accounting  of  a  trader  who  (1)  starts  in  business  with 
$5,000  cash,  (2)  buys  25  horses  for  $2,500  and  a  farm  for 
$2,000,  (3)  loses  5  horses  by  death,  (4) Brents  his  horses 
for  $100,  and  (5)  sells  the  remaining  20  horses  for  $3,000 
will  appear  as  follows: 

FORM  1. 


TRANSACTION. 

Cash 
Account. 

Miscellaneous  Assets 
Account. 

Proprietorship 
Account. 

Starts  business  v;ith  cash 
Buys   horses  and   farm 
for  cash  

+  $5,000 
—  4,500 

+  $2  500  (Horses) 

=    +$5,000 
=                0 

5  horses  die  

+   2,000  (Farm) 
—      500  (Horses) 

=    —      500 

Rents  horses  for  cash  .  .  . 
20  horses  sold  

+       100 
+  3  000 

—  2,000  (Horses) 

=    +       100 
-    +    1  000 

Closing  condition  

$3,600 

+  $2  000  (Farm) 

-    +  $5  600 

The  differentiation  here  made,  between  cash  and  all 
other  goods  is  an  important  one  because  Cash  is,  in  many 
respects,  the  most  important  form  of  Goods  and  also  (or 
therefore)  most  likely  to  be  stolen  unless  carefully  ac- 
counted for.  But  in  any  practical  set  of  books  there  is  of 
course  further  classification  of  the  Goods. 

"Where  sales  are  not  all  for  cash  the  account,  perhaps, 
aven  more  important  than  the  Cash  account  is  one  indi- 
cating the  amounts  due  from  customers.  This  is  especially 
necessary  where  the  bill  is  merely  charged  up  against  the 
customer's  account,  there  being  no  other  evidence  of  the 
debt  than  that  furnished  by  the  trader's  books.  A  primi- 


6  MODERN   ACCOUNTING 

live  form  of  such  an  account  is  the  slate  on  which  the  vil- 
lage tapster  "  chalks  up  the  P's  and  Q's  "  consumed  by 
his  regular  patrons.  But  in  any  systematic  business,  ac- 
counts must  be  kept  showing  claims  of  all  kinds,  both  the 
charge  accounts  and  those  evidenced  by  notes  given  by 
the  customer.  These  latter  can  again  be  divided  into  se- 
cured and  unsecured,  foreign  and  domestic,  time  and  de- 
mand, or  any  other  classification  appropriate  to  the  char- 
acter of  the  business  transaction.  Thus  the  differentiation 
is  continued,  real  property  separated  from  personal,  mer- 
chandise distinguished  from  plant,  and  still  further  sub- 
divided into  different  classes  as  for  instance,  dry  goods 
and  groceries,  each  of  these  divided  into  groups  such  as: 
silk  goods,  linens,  notions ;  flour,  tea  and  coffee,  sugar,  and 
thus  indefinitely  according  to  the  nature  of  the  business, 
the  taste  of  the  proprietor  and  the  particular  purpose  for 
which  the  accounts  are  kept.  No  rule  can  be  laid  down  as 
to  the  degree  to  which  ramifications  may  be  made,  as  each 
additional  subdivision  gives  to  the  proprietor  additional 
information  valuable  in  the  conduct  of  the  business.  The 
only  limit  is  that  at  some  point,  varying  with  the  particu* 
lar  business,  the  expense  of  getting  the  additional  infor- 
mation, requiring  as  it  does  more  books  and  more  clerks, 
is  greater  than  the  value  of  the  information  thus  gained. 
Somewhat  before  this  point  the  process  should  stop. 

In  certain  incomplete  systems  of  accounts  not  only  is  a 
differentiation  made  of  particular  assets,  but  these  selected 
assets  are  alone  considered,  all  other  Goods  being  altogether 
excluded  from  the  account  books.  Thus  in  that  bane  of 
domestic  peace,  the  household  expense  book,  as  it  is  gener- 
ally kept,  Cash  is  practically  the  only  asset  considered. 
No  difference  is  made  between  a  diminution  of  Cash  which 
represents  an  actual  loss,  as  when  it  is  dropped  on  the 
street,  given  in  charity,  or  paid  for  taxes,  and  one  which 
is  an  exchange  as  when  paid  for  a  permanent  asset,  for  in' 


DOUBLE   ENTEY   BOOKKEEPING 


stance  a  diamond.  Cash  only  is  considered;  other  assets, 
so  far  as  the  account  book  is  concerned  are  nonexistent. 
Another  stage  is  in  the  accounts  frequently  kept  by  small 
traders  by  so-called  single  entry,  in  which  the  only  assets 
shown  are  Cash,  and  the  claims  against  persons.  Other 
assets  are  entirely  excluded  from  the  books.  But  in  sys- 
tematic accounting  while  differentiation  of  assets  may  be 
carried  to  any  extent,  everything  owned  must  be  shown  in 
the  books  and  must  balance  with  the  items  representing 
Proprietorship. 

The  line  of  differentiation  of  Goods  accounts  may  be 
represented  as  follows: 

Mer-     f  Class  A 

..          T} 

chan-  -s       l(     Q 

I  etc. 

C  In  Till 

CashJ 


GOODS 


Positive 


(Assets) 


Nega- 
tive 

(Liabil- 
ities) 


disc 


Funds 


Credits 


f"A 

Bank^  B 

1C 

Invest- 
ments 


C  Accounts 
Com-     I  Receivable 
mercial  1  Bills  ("Time 

t  Receivable  -i  De- 
I  mand 


Plant 


Funded 


B 

fA 
Bonds-^  B 

la 

fA 

Mortgages-?  B 
1C 


Accounts  Payable 
Current*^  Bills  Payable 

Demand  Loans. 
1  etc. 


8  MODERN   ACCOUNTING 

This  scheme  is  merely  illustrative,  and  is  not  univer- 
sally applicable.  Not  only  do  different  enterprises,  say  a 
bank  and  a  railroad,  require  different  systems  of  classifi- 
cation, but  the  individual  establishments  in  a  given  trade, 
say  two  dry-goods  stores,  also  need,  each  its  own  system, 
adapted  to  its  particular  organization  and  business  meth- 
ods. For  the  sake  of  completeness  the  above  scheme  sub- 
divides Goods  into  Positive  and  Negative  Goods.  The 
latter  term  has  not  yet  been  used  in  the  text,  but  the 
subject  is  discussed  at  some  length  on  page  13. 

On  the  other  side  a  similar  division  of  the  Proprietor- 
ship account  appears.  The  first  and  most  obvious  division 
is  between  the  capital  at  the  beginning  of  the  business  and 
subsequent  additions  and  subtractions,  or  between  the 
Capital  and  Profit  and  Loss.  This  distinction  is  of  funda- 
mental importance  as  it  indicates  the  degree  to  which  the 
enterprise  is  successful.  As  the  measure  of  success  is  ex- 
pressed in  the  percentage  which  the  profits  gained  in  a 
single  year  bear  to  the  initial  capital,  tlje  Profit  and  Loss 
Account  is  ordinarily  a  temporary  one.  At  the  end  of  each 
fiscal  period  it  is  added  to  the  main  Proprietorship  account, 
or  otherwise  cleared  from  the  books.  During  the  fiscal 
period  the  Profit  and  Loss  account  may  be  further  subdi- 
vided into  accounts  representing  items  which  decrease  the 
net  wealth  and  those  which  cause  an  increase,  that  is,  into 
accounts  which  show  expenses,  or  losses,  and  those  which 
show  earnings. 

Thus  there  may  be  a  general  expense  account,  or  this 
may  be  divided  into  Wages,  Rent,  Interest,  Light,  Fuel  and 
so  forth.  Each  of  these  may  be  subdivided  to  correspond 
with  subdivisions  of  the  business.  Profit,  too,  is  divided 
into  its  various  elements,  such  as  Interest,  Profit  on  sale  of 
Dry  Goods,  Profit  on  sale  of  Groceries,  and  so  on  ad 
libitum.  Such  a  division  of  the  elemental  Proprietorship 
account  is  indicated  in  the  following  diagram : 


DOUBLE   ENTRY   BOOKKEEPING 


PROPRIETOR- 
SHIP 


{Contributed  by  A 
"  "  B 

"  C 

C  Surplus 

Accumu-J  Reserve  for  A 
lated    1  Reserve  for  B 
I      etc. 


Profit 
&    - 
Loss 


Current 


Accretions^ 
(Profits) 

r                 fDept.A 
On  Sales  \  Dept.  B 
t  Dept.  C 
Interest 

Other  gains 

Deductions 
(Losses)  * 

General  Expense 

Business  Losses, 
etc. 

It  should  be  noted  that  there  are  two  distinct  types  of 
differentiation  of  accounts.  In  one  class  a  subdivision  is 
made  into  several  coordinate  groups,  as  when  a  Merchan- 
dise account  is  divided  into  Groceries,  Dry  Goods,  Hard- 
ware, etc.  In  the  other  the  subdivision  of  an  account  is 
such  that  all  negative  items  are  placed  in  one  account, 
all  positive  items  in  another.  This  is  done  where  a  gen- 
eral Profit  and  Loss  Account  is  temporarily  split  up  into 
two  accounts,  one  showing  Losses  and  the  other  Gains. 

The  division  of  accounts  into  two  distinct  groups,  one 
representing  Goods  and  the  other  Proprietorship,  consti- 
tutes the  very  essence  of  double  entry  bookkeeping.  Yet 
the  clear  enunciation  of  this  principle  seems  not  to  have 
been  made  until  about  1830  when  it  was  set  forth  by 
Thomas  Jones,  an  American  accountant,  in  lectures  deliv- 
ered in  New  York.  He  showed  plainly  the  two  sets  of  ac- 
counts and  pointed  out  that  they  are  distinct  in  both 
content  and  purpose.  The  Goods  accounts  make  record  of 


10 

the  various  items  of  wealth  positive  and  negative,  showing 
all  the  details  of  assets  and  liabilities.  But  the  other  set, 
consisting  of  the  original  Proprietorship  and  the  Profit  and 
Loss  accounts,  serve  to  exhibit  the  amount  of  capital  in- 
vested at  the  beginning  of  the  period  and  the  gain  or  loss 
accruing  during  that  period.  By  means  of  the  various  sub- 
divisions, as  shown  in  the  above  diagram,  the  second  set  of 
accounts  shows  not  merely  the  total  net  profits  or  loss,  but 
as  well  the  various  sources  of  profit,  the  different  lines  of 
expense.  These  two  distinct  sets  of  accounts  must,  how- 
ever, agree  in  their  results.  Evidently  the  original  capital 
plus  the  net  profits,  which  is  the  showing  of  the  Proprie- 
torship accounts,  must  at  all  times  agree  with  the  net  assets, 
which  are  shown  by  the  Goods  accounts.  It  is  this  agree- 
ment between  the  Proprietorship  and  Goods  accounts 
which  serves  as  an  evidence  of  accuracy,  and  constitutes 
the  characteristic  merit  of  double  entry  bookkeeping. 
Books  might  be  kept  containing  only  one  or  the  other  of 
these  two  opposed  sets  of  accounts.  Single  entry  book- 
keeping contains  certain  Goods  accounts  but  omits  all  Profit 
and  Loss  items.  On  the  other  hand,  the  bookkeeping  of 
governments  and  of  charitable  organizations  have  for  their 
main,  if  not  their  sole  purpose,  the  exhibition  of  income  and 
expenses,  that  is,  of  certain  Proprietorship  accounts.  But 
in  systematic  commercial  bookkeeping  a  double  record  is 
kept,  both  Goods  and  Proprietorship  are  shown  in  full,  and 
the  two  sets  of  accounts  by  agreeing  serve  to  verify  the 
results. 

The  accounts  presented  have  thus  far  been  either  pure 
Goods  accounts  or  pure  Proprietorship  accounts.  Each 
account  showed  either  unmixed  Assets  or  unmixed  Proprie- 
torship. But  in  business  practice  many  transactions  are 
Mixed  Transactions  falling  under  class  c,  page  2.  where 
there  is  both  an  exchange  of  goods  and  an  element  of  profit. 
To  illustrate:  A  purchase  of  goods  is  a  pure  exchange 


DOUBLE   ENTRY   BOOKKEEPING  11 

transaction,  for  the  value  of  the  goods  is  uniformly  taken 
as  equaling  the  cash  paid  therefor,  say  one  hundred  dol- 
lars. A  receipt  of  interest  is  a  pure  profit  transaction, 
for  the  lender  still  holding  his  right  to  the  principal  in 
undiminished  value  receives  an  additional  Good,  that  is, 
ten  dollars  cash  paid  him  as  interest.  But  the  sale  of 
merchandise  should  be  a  mixed  transaction,  for  the  mer- 
chant exchanges  merchandise  costing  him  only  $100  for 
cash  amounting  to  $110.1 

The  mixed  transaction  can  be  correctly  portrayed  by 
the  use  of  unmixed  accounts  as  was  done  in  the  accounts 
on  page  5.  Here  the  $3,000  cash  received  is  in  fact  divided 
into  two  constituent  parts:  return  of  cost  price  of  horses 
$2,000  and  additional  cash  received  as  profit  $1,000.  The 
"  Miscellaneous  Assets  "  account  therefore  represented 
that  horses  worth  $2,000  were  parted  with,  the  cash  ac- 
count showed  the  receipt  of  $3,000  and  Proprietorship 
was  at  once  credited  with  $1,000  Profit.  The  tendency  to 
keep  fhe  Goods  accounts  thus  unmixed  is  increasing  in 
business  practice,  but  it  is  by  no  means  universal,  nor  even 
preponderant.  When  goods  are  sold  it  is  frequently  impos- 
sible, and  generally  difficult,  to  determine  how  much  the 
sold  goods  cost  and  how  much  of  the  selling  price  repre- 
sents profits.  The  salesman  knows  definitely  the  price 
called  for  by  the  bill  of  sale,  but  it  would  often  take  much 
complicated  reckoning  to  determine  the  actual  cost  of  the 


1  Theoretically  it  may  be  held,  that  the  profit  transaction  preceded 
the  exchange,  that  just  before  the  sale  the  merchandise  appreciated  to 
the  extent  of  ten  dollars,  and  the  increased  value  of  the  goods  must 
be  balanced  by  taking  recognition  of  the  profits.  After  this  there  is  a 
pure  exchange;  merchandise  worth  $110  being  exchanged  for  an  equal 
value  in  cash.  But  such  a  conception  is  at  variance  with  ordinary  com« 
mercial  expression,  and  is  thoroughly  opposed  to  what  is  a  cherished 
precept  of  accounting  practice  (even  though  it  is  not  a  principle  of 
accounting  theory)  namely:  that  it  is  dangerous  to  recognize  apprecia- 
tion of  goods  in  the  owner's  hands. 


12 


MODEKN  ACCOUNTING 


miscellaneous  assortment  of  merchandise  sold.  Conse- 
quently the  custom  in  ordinary  mercantile  establishments 
is  to  treat  the  Mixed  Transaction  as  if  it  were  a  pure  Ex- 
change Transaction,  and  in  the  accounts  to  represent  it  as 
though  the  goods  parted  with  were  of  the  same  value  as  the 
cash  received,  neither  profit  nor  loss  being  shown  at  the 
time.  Thus  a  merchant  having  capital  of  $2,500  all  in- 
vested in  merchandise,  and  selling  for  $110  a  bill  of  goods 
which  cost  him  only  $100  would,  if  his  account  were  kept 
unmixed,  show, 

FORM  2. 


TRANSACTION. 

Merchandise. 

Cash. 

Capital. 

Profits. 

Starts  in  business  with  
Sells  Mdse.  at  profit  

+  $2,500 
—       100 

+  $110 

=    +$2,500 

+  $10 

Closing  condition        

+  $2,400 

+  $110 

=    +$2  500 

+  $10 

But  in  ordinary  practice  the  accounts  would  appear 
thus: 

FORM  3. 


TRANSACTION. 

Merchandise. 

Cash. 

Capital. 

Profits. 

Starts  in  business  with  
Sells  merchandise  

+  $2,500 
-       110 

+  $110 

-    +$2,500 

o 

Cfosing  condition  

+  $2,390 

+  $110 

=    +$2,500 

The  Capital  account  here  stays  unchanged  at  $2,500 
and  no  entry  at  all  is  made  in  the  Profits  account.  The 
correct  equation  is  really 

Merchandise  $2,400  +  Cash  $110  =  Capital  $2,500  -|- 
Profits  $10. 

The  equation  shown  by  the  book  is : 

Merchandise  $2,390  -f  Cash  $110  =  Capital  $2,500  -f- 
Profit  0. 


DOUBLE  ENTKY  BOOKKEEPING      13 

which  is  incorrect  in  two  particulars.  It  shows  merchandise 
worth  $2,390  instead  of  $2,400,  and  the  total  proprietor- 
ship, that  is,  Capital  -j-  Profits,  as  $2,500  instead  of  $2,510. 

It  is  only  for  convenience'  sake  that  this  confessedly 
incorrect  statement  is  made.  It  is  necessary  at  some  later 
time  to  correct  the  errors.  This  is  ordinarily  done  by 
' '  taking  stock, ' '  that  is,  ascertaining  the  amount  and  value 
of  the  merchandise  actually  on  hand  and  making  an  entry 
in  the  books  to  correct  the  wrong  showing  of  the  merchan- 
dise account.  This,  of  course,  necessitates  another  entry 
at  the  same  time  in  the  Profits  account  in  order  to  main- 
tain the  proper  equation,  or  balance  of  the  books.  In  the 
example  given  above,  inspection  of  the  cash  drawer  shows 
$110  as  called  for  by  the  Cash  account.  But  an  inventory 
of  the  merchandise  on  the  shelves  shows  so  many  yards 
and  so  many  pounds  all  which  at  cost  are  worth  $2,400. 
But  the  Merchandise  Account  in  the  books  shows  $2,390, 
a  misstatement  which  must  be  corrected  by  increasing  the 
sum  $10.  Here  the  book  value  of  the  assets  is  increased 
by  $10.  Clearly  there  is  no  exchange.  Nothing  else  is 
diminished,  and  an  increase  in  the  total  book  value  of  all 
the  good  accounts  must,  if  the  equation  is  to  be  maintained, 
be  accompanied  by  a  corresponding  increase  in  one  of  the 
Proprietorship  accounts,  in  this  case  evidently  in  the  Prof- 
its account.  The  significance  to  bookkeeping  of  thus  rely- 
ing on  an  inventory  to  secure  correct  results  is  extremely 
great,  and  the  principles  of  making  such  an  inventory  are 
discussed  at  length  in  Chapter  IV. 

So  far  the  discussion  has  been  based  on  the  assumption 
that  the  merchant  does  business  entirely  on  his  own  capi- 
tal, that  he  has  not  borrowed  money,  nor  incurred  any 
other  obligation.  In  actual  business  this  is  seldom  true, 
and  it  is  accordingly  necessary  to  see  how  liabilities  of  the 
proprietor  are  Created  in  accounting.  If  one  has  a  stock 
of  merchandise  on  hand,  worth  $10,000,  half  of  which  was 


14  MODEKN   ACCOUNTING 

.paid  for  in  cash  and  the  other  half  bought  on  credit,  the 
equation  cannot  stand: 

Goods  on  hand  $10,000  —  Proprietorship  $5,000. 
It  is  however  perfectly  correct  to  make  the  statement : 

Total  goods  on  hand  $10,000  —  Amount  due  to  creditor 
$5,000  =  Proprietorship  $5,000. 

Proprietorship  represents  the  net  wealth,  not  the  gross 
assets  of  the  proprietor.  It  is  true  that  legally  the  goods 
bought  on  credit  or  with  borrowed  money  are  the  property 
of  the  purchaser,  belonging  absolutely  to  him.  But  eco- 
nomically there  is  a  divided  ownership  and  the  credit  in- 
strument is  merely  a  form  of  title  to  an  undivided  half  of 
a  certain  mass  of  valuable  goods.  Liabilities,— that  is, 
debts  of  any  kind,— may  therefore  be  considered  as  Nega- 
tive Goods,  the  assets  being  Positive  Goods.  While  the  pro- 
prietor holds  and  legally  owns  $10,000  worth  of  assets  he 
also  has  $5,000  worth  of  Negative  Goods  which  must  be 
subtracted  from  the  Positive  Goods  to  determine  the  net 
proprietorship.  But  just  as  in  algebraic  equations  a  nega- 
tive term  in  one  member  may  be  transferred  to  the  other 
member  thereby  becoming  positive,  so  in  the  bookkeeping 
equation  the  form  is  ordinarily 

Goods  $10,000  =  Proprietorship  $5,000  +  Debts  $5,000. 

This  simple  conception  of  negative  items  is  of  great  impor- 
tance to  bookkeeping,  applying  not  alone  to  the  relation- 
ship of  debts,  but  to  other  subtractions  which  are  made  fop 
technical  purposes.  In  accounting,  it  is  always  legiti- 
mate, whenever  a  sum  is  to  be  subtracted  from  an  amount 
appearing  on  one  side  of  the  equation,  to  place  it  instead 
as  a  positive  item  on  the  other  side.  It  is  entirely  imma- 
terial whether  one  writes 

a  —  b  =  c  or  a  =  c      b. 


DOUBLE  ENTRY  BOOKKEEPING      15 

On  these  few  principles  rests  the  whole  structure  of 
double  entry  bookkeeping.  Summing  up : 

1.  There  is  an  initial  equation  made  between   Goods 
possessed  and  Proprietorship. 

2.  Either  side  of  this  equation  may  be  ramified  indefi- 
nitely to  suit  the  needs  of  the  individual  business. 

3.  Negative  items  appear,  which  instead  of  being  im- 
mediately subtracted  may  be  placed  as  positive  items  on 
the  other  side  of  the  equation.     Thus— e.  g.,  items  repre- 
senting Negative  Goods  or  debts  are  not  subtracted  from 
the  Positive  Goods    (assets),  but  are  transferred  to  the 
other  side  of  the  equation  and  added  to  the  items  repre- 
senting Proprietorship. 

4.  In  all  subsequent  transactions  it  is  necessary  to  pre- 
serve the  equation  as  follows: 

(a)  An  addition  to  one  of  the  Goods  account  may  be 
offset  by  a  subtraction  from  andther  Goods  account. 

(6)  An  addition  to,  or  subtraction  from  one  Goods  ac- 
count may  be  offset  by  a  similar  addition  to,  or  subtraction 
from  a  Proprietorship  account. 

(c)  Addition  and  subtraction  are  here  used  in  the 
algebraic  sense,  a  subtraction  from  a  negative  account  be- 
ing equivalent  to  addition. 


CHAPTER    II 

THE    THEORY    OF    DOUBLE    ENTRY    BOOKKEEPING    (continued} 

THE  discussion  has  thus  far  been  in  most  general  terms 
and  with  no  reference  to  the  details  of  bookkeeping  tech- 
nic.  This  has  been  done  advisedly,  in  order  that  the  prin- 
ciples might  be  presented  unrelated  to  conventional  prac- 
tice. In  just  what  form  the  equation  described  is  to  be 
written,  how  the  books  are  to  be*  ruled  and  paged,  how 
items  are  to  be  gathered  together  for  adding,  whether 
columns  are  to  be  run  perpendicularly  or  horizontally, 
whether  items  are  to  be  entered  directly  into  a  particular 
book  or  to  be  transferred  to  it  from  another  book  of  origi- 
nal entry ;  all  these  and  many  other  details  may  be  impor- 
tant in  securing  efficient  bookkeeping.  They  may  affect  the 
ease  with  which  the  record  of  business  operations  is  made 
and  transcribed,  or  the  readiness  with  which  certain  facts 
are  ascertained  from  an  inspection  of  the  books ;  they  may 
aid  in  preventing  error  and  detecting  fraud.  But  after 
all.  these  are  variations  in  technic,  not  matters  of  princi- 
ple. The  essential  thing  in  any  form  of  double  entry  book- 
keeping is  that  there  is  somewhere  a  number  of  items  rep- 
resenting what  are  here  called  Goods  accounts,  and  some- 
where in  the  books  another  set  of  items  which  are  here 
called  Proprietorship  accounts.  The  sum  of  these  Goods 
items,  taking  in  account  the  Negative  Goods,  or  debts, 
must  equal  the  algebraic  sum  of  the  Proprietorship  items. 

Nevertheless  the  points  of  more  general  acceptance  in 
bookkeeping  convention  should  not  be  neglected,  although  * 
it  must  be  remembered  that  even  the  most  deepseated  con- 

16 


DOUBLE  ENTRY  BOOKKEEPING       17 

ventions  in  bookkeeping  could  all  be  violated  without,  in 
the  least,  affecting  the  essentials  of  the  system. 

In  whatever  form  the  first  record  of  the  transaction  is 
made,  it  is  customary  to  have  the  items  of  similar  nature 
gathered  together  on  a  page  of  a  book  (which  may  indeed 
be  loosely  bound,  or  even  consist  of  unbound  sheets  or 
cards)  which  is  called  the  Ledger.  Although  legally  the 
ledger  is  treated  as  an  inferior  book,  its  validity  in  court 
being  less  than  that  of  the  books  from  which  the  ledger 
entries  are  ordinarily  transferred,  it  is  in  bookkeeping  the 
most  important,  the  essential  book,  as  is  indicated  by  the 
names  which  have  been  given  it  in  other  tongues,  Libro 
Mcestro,  Grand  Livre,  Hauptbuch.  It  is  possible  to  use 
the  ledger  alone.  This  was  customary  among  the  earlier 
Venetian  accountants  and  even  to-day  it  is  the  method  oc- 
casionally employed,  with  correct  results,  for  keeping  sim- 
ple accounts. 

But  in  a  large  business  the  use  of  a  ledger  alone  is 
clearly  impossible,  and  even  in  a  small  establishment  such 
a  system,  while  possible,  is  unsatisfactory.  The  chief  trou- 
ble is  the  difficulty  of  detecting  errors.  The  use  therefore 
of  some  chronological  record  of  transactions,  in  contradis- 
tinction to  the  ledger  where  entries  are  classified,  while 
multiplying  the  writing  to  be  done  is  really  an  economy. 
It  is  easier  to  make  the  original  entries  in  such  a  book; 
the  entries  are  less  liable  to  error ;  an  error  once  made  can 
more  easily  be  detected. 

In  each  of  the  ledger  accounts  there  will  be  certain 
items  to  be  added,  certain  other  items  to  be  subtracted.  In 
early  bookkeeping  these  items  were  all  listed  in  a  single 
column,  addition  or  subtraction  being  indicated.  This  is 
the  form  which  has  thus  far  been  used  in  the  pages  of  this 
treatise ;  it  is  in  some  cases  still  used  in  modern  bookkeep- 
ing practice  where  the  items  to  be  subtracted  are  generally 
differentiated  by  being  written  in  a  different  colored  ink. 


18 


MODERN   ACCOUNTING 


But  it  is  apparent  that  with  a  single  column  there  is  a 
great  danger  that  the  bookkeeper  will  make  the  mistake  of 
adding  where  he  should  subtract  or  of  subtracting  where 
he  should  add.  It  was  therefore  a  very  valuable,  though 
a  simple  device,  to  separate  the  items  to  be  added  from 
those  to  be  subtracted.  Thus  the  cash  account  given  on 
page  5  instead  of  appearing  as  it  does  there  in  the  form : 

FORM  4. 
Cash  Account. 

Amount  with  which  business  started +$5,000 

Paid  for  Horses —  2,500 

Paid  for  Farm —  2,000 

Received  for  Rental +  100 

Received  for  Horses +  3,000 

Amount  on  hand +$3,600 

is  presented  with  positive  and  negative  items  separated 
thus: 

FORM  5. 
Cash  Account. 


Amount  with  which  started 

business $5,000 

Received  for  Rental 100 

Received  for  Horses 3,000 


Total..  ..$8,100 


Paid  for  Horses $2,500 

Paid  for  Farm 2,000 

$4,500 
Balance 3,600 

$8,100 


Balance $3,600 

The  word  "  Balance  "  as  here  used  signifies  merely 
the  difference  between  the  sum  of  the  positive  and  the  sum 
of  the  negative  items,  or  the  algebraic  sum  of  all  the  items. 
It  is  customary,  but  by  no  means  necessary  to  add  the 
' '  Balance  ' '  to  the  smaller  of  the  two  sides  so  as  to  produce 
the  same  total  at  the  foot  of  each  column.  This  is  less 
rigidly  done  in  recent  years  than  formerly,  as  in  many 
ledgers  special  column  rulings  (described  in  Chapter  XIX) 
render  the  formal  balancing  of  the  accounts  unnecessary. 


DOUBLE   ENTRY   BOOKKEEPING  19 

Certain  of  the  accounts  thus  presented  in  double  col- 
umn will  represent  positive  Goods  or  Assets.  It  is  a  con- 
vention well-nigh  unbroken,  although  its  violation  in  no 
way  affects  the  results  to  be  gained  by  double  entry  book- 
keeping, to  list  the  items  representing  Goods  on  hand,  or 
subsequently  acquired,  in  the  first  or  left  hand  column, 
the  subtractions  therefrom  in  the  second,  or  right  hand  col- 
umn. In  all  Assets  accounts  the  left  hand  column  is  there- 
fore the  positive  column,  the  right  hand  column  containing 
the  negative  entries. 

It  is  a  further  convention  applicable  to  all  accounts  to 
call  the  left  hand  column  ' '  Debit  ' '  and  the  entries  therein 
Debit  entries.  The  act  of  making  a  Debit  entry  is  called 
Debiting  or  charging  an  account.  The  right  hand  column 
is  called  "  Credit,"  the  entries  therein  Credit  entries,  and 
the  act  of  making  such  an  entry  Crediting  an  account. 

Furthermore  the  normal  condition  of  all  Asset  accounts 
is  to  have  positive — that  is,  a  Debit  excess  of  values.  As- 
sets, things  which  one  possesses  evidently  are  positive. 
One  may  lose  them  all,  or  pay  them  all  away  but  normally 
the  limit  is  zero.  Fire  may  burn  all  but  not  more  than  all 
of  the  merchandise;  one  may  pay  out  all  the  Cash  in  the 
drawer,  but  it  is  difficult  to  squeeze  it  so  as  to  make  it  pay 
out  more  than  was  put  in.  Thus,  while  in  rather  technical 
bookkeeping  entries  an  asset  account  may  show  an  excess 
on  the  credit  side,  such  is  not  the  normal  condition,  and 
always  requires  interpretation.1 

Another  class  of  accounts  will  represent  the  Proprietor- 
ship accounts  and  these  too  will  be  divided  into  two  col- 
umns. The  Proprietorship  account  presented  on  page  5 

1  A  good  illustration  is  where  the  cash  account  is  kept  so  as  to  include 
not  merely  cash  in  the  till,  but  also  cash  deposited  in  the  bank.  Now, 
while  the  till  cannot  give  out  an  excess,  it  is  sometimes  possible  to  pay 
out  by  check  in  excess  of  the  amount  on  deposit.  In  such  a  case  the 
Cash  account,  normally  the  highest  type  of  a  pure  positive  Goods 
(Assets)  account  may  show  a  negative  balance. 


20 


MODEKN   ACCOUNTING 


FORM  6. 
Proprietorship  Account. 

Original  capital +$5,000 

Loss  by  death —      500 

Profit  by  rental +       100 

Profit  by  sale +   1,000 

Net  proprietorship +  $5,600 


becomes 


Dr.(-) 


FORM  7. 

Proprietorship  Account. 


Cr.  (+) 


Loss  by  death $500 

Balance 5,600 


Total $6,100 


Original  capital $5,000 

Profit  by  rental 100 

Profit  by  sales 1,000 

Total..  ..$6.100 


Balance $5,600 


A  striking  contrast  between  the  account  showing  an 
asset  and  one  indicating  Proprietorship  is  to  be  noted.  In 
the  former  the  positive  items  appear  in  the  left  hand  col- 
umn and  are  hence  Debits ;  in  the  Proprietorship  accounts 
the  positive  items  appear  in  the  right  hand  column  and  are 
hence  Credits.  In  one  class  of  accounts  therefore  Debits 
are  positive  and  in  the  other  class  they  are  negative.  This 
confusing  use  of  the  terms  Debit  and  Credit  has  been  one 
of  the  most  perplexing  points  in  accounting  practice. 

Undoubtedly  the  terms  were  originally  used  in  their 
strict  sense  of  indicating  a  Debtor  or  a  Creditor  and  in 
accounts  showing  such  relationships  they  still  maintain 
their  original  meaning  in  full  force.  If  an  advance  of 
$100  is  made  to  A  it  constitutes  him  a  Debtor  to  that 
amount,  and  this  is  shown  by  charging  or  Debiting  hi« 
account,  which  is  conventionally  done  by  an  entry  in  the 
left  hand  side.  Should  A  repay  the  $100  it  of  course  can- 
cels the  charge,  which  is  shown  by  entering  $100  in  the 


DOUBLE   ENTRY   BOOKKEEPING  21 

right  hand  column.  If  he  in  turn  advances  more  than  the 
$100  it  transforms  him  from  a  Debtor  to  a  Creditor,  so 
that  it  is  not  unnatural  that  with  Debits  on  the  left  hand 
the  right  hand  column  should  be  called  Credit.  This  orig- 
inal meaning  of  Debit  and  Credit  is  still  preserved  in  per- 
sonal accounts.  But  the  application  of  Debit  and  Credit  to 
other  classes  of  accounts  is  more  difficult  of  explanation. 

It  may  not  be  unreasonable  for  the  merchant  having 
become  accustomed  to  list  that  most  important  class  of 
assets,  claims  against  customers,  as  Debits,  to  treat  other 
assets  in  the  same  manner.  Most  writers  have  gone  fur- 
ther in  attempting  an  explanation  and  have  assumed  that 
Debit  and  Credit  in  all  accounts,  whether  representing 
debt  relations,  or  other  Assets,  or  even  Proprietorship, 
show  a  relationship  of  Debtor  and  Creditor.  This  is  ac- 
complished by  a  rather  forced  system  of  personification. 
Thus  for  instance  Cash,  or  Merchandise  is  personified  as 
being  a  Cashier  or  a  Store  Keeper,  who  is  in  turn  indebted 
to  the  business  for  all  values  which  have  gone  into  his 
hands.  On  the  other  hand  the  Proprietor,  contrary  to  the 
legal  fact,  is  assumed  to  be  a  Creditor  of  the  business. 
These  are  perhaps  not  so  bad,  but  when  the  same  theory  of 
personification  is  carried  to  such  accounts  as  Expense, 
Profit  and  Loss,  etc.,  it  becomes  difficult  of  application  and 
of  less  than  doubtful  value.  The  better  theory  rejects  all 
this  personification  and,  as  is  done  in  this  book,  treats  the 
two  sets  of  accounts  as  representing  two  different  concep- 
tions, each  of  which  has  its  own  value  and  meaning,  and  in 
which  Debit  and  Credit  are  used  conventionally  with  dif- 
fering signification. 

Thomas  Jones,  writing  about  seventy  years  ago,  said: 
"  All  debits  are  not  sums  owing  to  us,  nor  are  all  credits 
sums  we  owe.  Some  debit  items  are  owing  to  us,  others 
(Stock)  are  sums  withdrawn  by  us;  some  (Merchandise) 
are  sums  paid,  others  (Cash)  are  sums  received;  and  the 


22  MODERN  ACCOUNTING 

credit  items  also  stand  for  equally  dissimilar  facts.  From 
which  it  must  be  evident  that  these  terms  are  used  arbi- 
trarily, and  any  attempt  to  exhibit  them  in  one  uniform 
relation  of  indebtedness  must  necessarily  oblige  us  either 
to  use  language  of  corresponding  ambiguity,  or  resort  to 
the  personification  of  things  which  not  only  have  no  exist- 
ence but  the  indebtedness  of  which  cannot  possibly  have 
any  apparent  influence  on  the  end  we  aim  to  accomplish. 
As  names,  enabling  us  to  designate  which  side  of  any  ac- 
count we  may  refer  to  or  speak  of,  they  answer  our  pur- 
pose ;  and  so  would  the  terms  blue  column  and  red  column, 
equally  well,  if  custom  permitted  their  use.  In  personal 
accounts  they  bear  a  literal  meaning ;  and  by  analogy  they 
have  been  extended  to  all  other  accounts ;  but  the  relations 
which  constitute  that  analogy  are  too  obscure  to  be  of  use 
as  a  guide  to  the  student,  and  are  more  calculated  to  mys- 
tify than  explain  the  subject." 1 

And  Colonel  Charles  E.  Sprague  in  his  "  Philosophy  of 
Accounts  ' '  says  that  those  who  make  such  a  personification 
of  the  business  have  been  "  misled  by  the  lazy  habit  of 
bookkeepers  in  calling  all  Credit  balances  liabilities  al- 
though they  know  that  some  of  those  balances  are  not  lia- 
bilities. Even  admitting  that  there  is  a  fictitious  entity  it 
owes  nothing  to  the  real  owners  "  (p.  33). 

While  it  is  true  that  most  of  the  intervening  authors 
present  unquestioningly  the  nai've  personalistic  theory,  it 
is  interesting  to  note  that  Jones  who  was  the  first,  and 
Sprague  the  latest  and  most  penetrating  American  theoret- 
ical writer  are  thus  in  accord.  And  on  their  side  are  found 
many  of  the  leading  European  authorities,  among  whom 
may  be  mentioned  Hiigli  and  Schaer. 

Reference  has  been  made  to  the  confusion  caused  by 
Mixed  Accounts,— that  is,  accounts  in  which  the  element 

1  Principles  and  Practice  of  Bookkeeping,  p.  21. 


DOUBLE   ENTRY   BOOKKEEPING  23 

of  Profit  is  entered  without  separation  from  the  exchange 
element.  Thus  where  merchandise  is  purchased  for  $100 
the  Merchandise  account  is  debited  with  that  amount.  If 
half  the  Merchandise  is  sold  for  $75  the  account  is  ordi- 
narily credited  with  that  entire  sum,  instead  of  crediting 
Merchandise  with  $50  and  Profit  and  Loss  with  $25.  This 
results  in  a  balance  in  the  Merchandise  account  which 
does  not  show  the  value  of  the  unsold  stock,  but  that  sum 
less  the  profits  on  the  goods  sold.  Mixed  accounts  are 
cleared  at  intervals  by  crediting  the  account  with  the  in- 
ventory value  of  goods  on  hand,  leaving  a  difference  be- 
tween the  total  debits  and  the  total  credits  of  the  account, 
corresponding  to  the  profits  realized.  The  inventory  being 
brought  down  as  the  balance  on  the  new  Merchandise  ac- 
count, that  again  starts  out  as  a  pure  Goods  account. 
This  may  be  illustrated  algebraically  as  follows: 

The  cost  price  of  the  merchandise  (C)  =  Cost  of  Merchan- 
dise sold  (Sx)  -{-Inventory  (I). 

Amount  received  for  sales  (S)  =  Cost  of  Merchandise  sold 
(SJ+ Profit  (P). 

Therefore  C  —  S  =  I  —  P.  But  C  —  S  is  the  Balance  (B) 
shown  in  the  Merchandise  Account  before  the  introduction 
of  the  Inventory.  Hence  I  —  B  =  P.  The  crediting  of 
the  Inventory  is  equivalent  to  subtracting  the  outstanding 
balance,  so  that  the  remainder  indicates  the  amount  of 
Profits. 

The  reversal  of  the  positive  sides  in  the  two  classes  of 
accounts  (Goods  accounts  and  Proprietorship  accounts)  is 
of  considerable  importance  in  the  technic  of  bookkeeping. 
It  has  already  been  shown  that  the  fundamental  equation 
running  through  all  accounting  is  one  in  which  Goods,  or, 
ignoring  debts,  Assets  equal  Proprietorship.  But  assets 
are  conventionally  listed  in  the  left  hand  column  and  hen  36 


24  MODEKN   ACCOUNTING 

show  Debit  excesses  or  balances.  Proprietorship  is  con- 
ventionally listed  in  the  right  hand  column  and  hence  the 
balances  are  Credits.  Consequently  the  fundamental  equa- 
tion is  one  in  which 

Assets   (Debits)  =  Proprietorship   (Credits) 

so  that  there  is  an  equivalence  not  merely  between  Assets 
and  Proprietorship  but  also  between  Debits  and  Credits. 
The  significance  of  this  is  discussed  on  a  following  page. 

In  addition  to  the  two  classes  of  accounts  just  men- 
tioned—namely, accounts  showing  Assets  and  normally 
having  debit  excesses,  and  Proprietorship  accounts  with  a 
normal  credit  excess,  the  scheme  of  accounts  contains  two 
other  groups  referred  to  on  page  13.  These  are  Negative 
Goods  accounts,  of  which  Debts  Payable  may  be  taken  as  a 
'type,  and  Negative  Proprietorship  accounts,  typified  by 
the  Expense  account.  Considering  first  the  Negative  Goods 
accounts  it  is  seen  that  they  are  items  which  might  logic- 
ally have  been  entered  to  the  credit  of  some  asset  account. 
To  illustrate:  If  a  piece  of  real  estate  is  purchased  for 
$20,000,  of  which  $15,000  is  paid  in  cash  and  the  balance 
is  still  due,  it  would  not  be  illogical  (although  the  prac- 
tice is  condemned  by  accountants,  and  in  cases,  is  even 
considered  fraudulent  misrepresentation)  to  record  the 
transaction  thus: 

FORM  8. 
Dr.  (+)  Real  Estate.  (-)  Cr. 


Land  and  buildings $20,000       Due  on  purchase  price $5,00(1 


in  which  the  debt  appears  as  an  immediate  subtraction 
from  the  total  value  of  the  property.  But  for  the  sake  of 
clearly  showing  the  exact  status,  it  is  much  better  to  sepa- 
rate these  two  items,  thus : 


DOUBLE    ENTRY   BOOKKEEPING 


25 


Dr.  (+) 


FORM  9. 
Real  Estate. 


(-)CV. 


Land  and  buildings $20,000 


FORM  10. 

Debts  Payable. 


(-)  Cr. 


Due  on  real  estate $5,000 


This  not  only  shows  the  present  situation  more  clearly, 
but  also  allows  for  further  details,  for  the  Credit  column 
of  the  Real  Estate  account  can  now  show  other  deduc- 
tions from  the  value  of  the  Real  Estate  quite  different 
from  the  unpaid  portion  of  the  purchase  price.  Thus  if 
fire  damages  the  building  to  the  extent  of  $1,000  the  Real 
Estate  account  will  show: 


FORM  11. 
Real  Estate, 


Land  and  building $20,000       Damage  by  fire $1,000 


The  Debit  column  of  the  Debts  Payable  account  can  be 
used  to  show  payments  on  account  thus : 


Dr.  (+) 


FORM  12. 
Debts  Payable. 


Paid  on  account. 


1,000 


Due  on  real  estate $5,000 


The  showing  thus  made  is  much  more  explicit  than  if  all 
four  items  were  lumped  together  thus: 


26 

Dr.  (+) 


MODERN"   ACCOUNTING 

FORM  13. 
Real  Estate. 


(-)C'r. 


Land  and  building $20,000 

Paid  on  account 1,000 


Due  on  purchase  price $5,000 

Loss  by  fire 1,000 


although  in  both  methods  the  net  assets  must  be  the  same 
$15,000. 

In  so  far  as  debts  are  considered  as  subtractions  from 
assets  they  must  appear  in  a  credit  column,  for  it  is  in 
that  column  that  any  deductions  from  assets  appear.  But 
a  cleavage  takes  place,  and  a  separate  account  is  estab- 
lished to  represent  debts.  The  mortgage  shown  in  Form  8 
no  longer  appears  in  the  credit  column  of  the  Real  Estate 
account  but  in  the  credit  column  of  a  separate  Debts  Pay- 
able account.  Every  new  debt  incurred  or  every  addition 
to  outstanding  debts  necessarily  appears  in  a  similar  col- 
umn, while  any  debt  paid,  or  otherwise  canceled  is  placed 
among  the  debits,  for  here  as  elsewhere  in  accounting  the 
two  sides  of  any  account  are  opposed  one  to  the  other -and 
tend  one  to  cancel  the  other.  A  statement  of  the  Goods 
would  therefore  show : 

Real  Estate  $20,000  +  (—  Debts  $5,000)  =  $15,000 
for  by  the  simplest  algebraic  principle  the  effect  of  adding 
a  negative  is  the  same  as  subtracting. 

But  subtraction  is  at  best  a  clumsy  process,  and  again 
by  ordinary  algebraic  principles  it  is  customary  to  trans- 
fer all  such  negative  items  to  the  other  member  of  the 
equation  with  an  accompanying  change  of  sign,  so  that  the 
equation  becomes 


Real  Estate 


FORM  14. 
Proprietorship 


Dr.  (+) 
$20,000 


•f 


Debts  Payable 


Cr.  (-)  Dr.(-) 

It   follows   therefore   that  in   all  accounts   indicating 


CV.  (+) 
$15,000 


Dr.(-)      Cr.  (+) 
$5,000 


DOUBLE  ENTRY  BOOKKEEPING      27 

debts  the  balance  is  normally  on  the  Credit  side.  And 
while  it  is  true  that  a  credit  in  a  debt  account  indicates  a 
subtraction  from  the  total  assets  of  the  proprietor,  yet  in 
itself  the  Credit  side  of  the  Debt  account  may  be  consid- 
ered the  positive  side.  This  is  true  in  the  sense  that  an 
existing  debt  appears  on  that  side,  and  that  the  cancela- 
tion  of  a  debt  is  performed  by  making  an  entry  among  the 
Debits.  In  form  therefore  the  Debt  or  Liability  accounts, 
as  they  are  ordinarily  called,  agree  with  the  Proprietor- 
ship accounts,  in  having  normally  a  credit  balance.  Agree- 
ing thus  with  the  Proprietorship  accounts  they  necessarily 
differ  from  the  Asset  accounts  which  normally  have  a 
Debit  balance.  "While  this  may  be  a  little  confusing  at 
first  to  the  student  it  is  in  perfect  accord  with  algebraic 
principles  and  should  offer  no  permanent  difficulty. 

The  uses  of  Debit  and  Credit  in  the  various  classes  of 
accounts  may  be  represented  schematically  thus: 


Assets. 

Proprietorship. 

Debts. 

Debit  

+ 

Credit              

+ 

-f 

All  that  has  been  said  regarding  the  Negative  Goods 
accounts  can  be  said,  mutatis  mutandis,,  of  the  Negative 
Proprietorship  accounts,  of  which  expense  is  taken  as  type. 
An  expense  being  an  outlay  of  goods  (e.  g.,  cash)  without 
the  receipt  of  some  other  equivalent  Good  *  it  can  only  sig- 

1  From  the  economic  viewpoint  even  an  expense  involves  the  ex- 
change of  equivalents,  but  this  is  for  convenience'  sake,  disregarded 
by  the  accountant.  For  instance  the  wages  paid  to  a  watchman  is 
treated  as  an  expense,  for  the  services  which  he  gives  in  return,  are  not 
considered  as  a  "Good"  to  be  taken  into  account.  Even  when  there 
is  a  tangible  equivalent  received  in  return  for  the  payment  the  account- 
ant may  at  times  disregard  it  in  his  accounts,  as  for  instance,  the  cost 
of  repainting  a  house  is  treated  as  an  expense,  although  for  part  of  the 
money  expended  there  was  received  an  equivalent  value  of  white  lead. 


28  MODERN   ACCOUNTING 

nify  that  the  total  Proprietorship  has  been  lessened.  A 
diminution  of  the  Proprietor's  capital  can  be  indicated  by 
debiting  the  Capital  account  thus: 

FORM  15. 
Dr.  (  — )  Proprietor's  Capital.  («f )  Cr. 

Expenses  paid $500  |j  Original  capital $15,000 

but  it  is  more  satisfactory  temporarily  to  segregate  such 
Expense  items,  putting  them  into  a  separate  account,  and 
transferring  this  account,  which  must  normally  have  a 
Debit  excess,  to  the  left  hand  member  of  the  equation. 
Here  it  can  conveniently  be  added  to  the  Asset  accounts 
which  similarly  have  a  Debit  excess.  Thus  all  Negative 
Proprietorship  accounts,  Expense,  Profit  and  Loss  (where 
there  is  a  deficiency),  and  other  similar  accounts  have  the 
Debits  in  excess.  In  this  respect  they  resemble  the  Asset 
accounts,  and  consequently  are  in  contrast  to  the  Capital 
account  and  to  those  showing  Debts. 
The  equation  of  accounts,  first  given 

Goods  accounts  (Debit)  =  Proprietorship  account  (Credit) 
becomes : 

Assets  (Debit)  —  Debts  (Credit)  =  Capital  account 
(Credit)  -f-  Profits  (Credit)  —  Negative  Proprietor- 
ship accounts  (Debit) 

and  by  transposition : 

Assets  (Debit)  -f-  Negative  Proprietorship  accounts 
(Debit)  =  Capital  account  (Credit)  -f-  Profits  (Cred- 
it) +  Debts  (Credit) 

or  finally  as  values  are  expressed  in  figures,  and  can  more 
conveniently  be  added  vertically  than  horizontally,  the 
equation  becomes: 


DOUBLE   ENTRY  BOOKKEEPING  29 

FORM  16. 
Debit  Credit 

Assets  Sapital 

Expenses  Profits 

Loss,  etc.  Debts,  etc. 


Total  Debits  -  Total  Credits 

In  any  set  of  books  therefore  the  total  debits  should 
equal  the  total  credits  and  this  is  true  whether  the  total 
of  all  debits  is  compared  with  the  total  of  all  credits,  or 
whether  the  comparison  is  made  between  the  sum  of  debit 
balances  and  the  sum  of  credit  balances.  In  the  routine 
of  bookkeeping  this  is  of  great  service,  furnishing  the  most 
frequently  used  criterion  as  to  the  correctness  of  the  books. 
Without  inquiring  further  as  to  the  nature  of  the  accounts, 
or  the  significance  of  the  various  outstanding  balances,  the 
bookkeeper  ascertains  at  regular  or  frequent  intervals 
whether  the  Debits  and  the  Credits  in  his  ledger  are  equal. 
If  this  is  the  case  the  ledger  is  said  to  balance.  For  ordi- 
nary purposes  such  a  balancing  is  taken  as  evidence,  in- 
conclusive though  it  may  be,  that  there  are  no  errors  in 
the  bookkeeper 's  work. 

Certainly  a  ledger  is  incorrect  so  long  as  it  fails  to  bal- 
ance, but  the  evidence  from  balancing  is  not  conclusive. 
It  does  show  that  there  has  been  a  Credit  for  every  Debit. 
But  it  does  not  show  whether  a  transaction  which  should 
have  been  entered  is  altogether  omitted;  it  does  not  indi- 
cate transpositions  which  may  have  been  made,  nor  errors 
of  equal  amount  made  in  both  the  Debit  and  Credit  post- 
ing. It  does  not  show  that  an  item  has  not  been  entered 
in  Merchandise  which  should  have  gone  into  Real  Estate 
which  would  make  a  wrong  showing  of  the  kind  of  assets 
held.  More  unfortunately  it  does  not  show  whether  items 
have  gone  say  into  Real  Estate  which  should  have  been 
entered  in  Expense,  which  would  cause  the  more  important 


30  MODERN  ACCOUNTING 

double  error  of  misrepresenting  the  total  value  of  Goods 
and  showing  an  incorrect  net  Proprietorship. 

A  system  of  accounts  in  which  similar  items  are  classi- 
fied and  grouped,  and  in  which  the  Debits  always  equal  the 
Credits  contains  all  the  formal  requirements  of  double 
entry  bookkeeping.  To  keep  such  a  set  of  accounts  it  is 
necessary  to  understand  clearly  the  nature  of  each  transac- 
tion. If  it  is  an  actual  business  transaction  in  contradis- 
tinction to  a  mere  act  of  classification,  it  must  affect  one  of 
the  Goods  accounts,  either  Assets  or  Liabilities.  If  the 
total  Goods  are  increased  or  decreased,  one  of  the  Propri- 
etorship accounts  must  be  similarly  affected.  If  there  is 
no  change  in  the  total  Goods  a  change  in  one  of  the  Goods 
accounts  must  evidently  be  balanced  by.  a  contrary  change 
in  another  Goods  account.  If  any  one  of  the  assets  shows 
an  increase  it  must  evidently  be  Debited,  which  compels  a 
corresponding  credit  elsewhere.  By  keeping  clearly  in 
mind  the  nature  of  the  accounting  system  and  that  it  is 
attempting  to  present  a  true  equation  between  Net  Goods 
and  Net  Proprietorship,  there  need  be  no  great  difficulty 
in  correctly  recording  any  transaction. 

This  system  of  double  entry  bookkeeping,  which  has 
been  the  recognized  form  throughout  the  commercial 
world  for  half  a  millennium,  is  to  be  counted  among  the 
greatest  aids  to  commerce.  Perhaps  Goethe  may  be  justi- 
fied in  declaring  it  "  One  of  the  fairest  inventions  of  the 
human  mind."  Nevertheless  exaggerated  claims  are  some- 
times made  in  behalf  cf  double  entry  bookkeeping,  espe- 
cially in  comparisons  made  between  double  entry  and  the 
less  systematic  form  known  as  single  entry  bookkeeping. 
Not  infrequently  is  the  statement  made  that  double  entry 
bookkeeping  possesses  the  advantage  of  showing  at  any 
time,  not  only  the  amounts  of  money  due  on  current  ac- 
counts but  also  the  status  of  the  business,  what  its  profits 
and  losses  have  been.  This  is  clearly  an  exaggeration  so  far 


DOUBLE  ENTRY  BOOKKEEPING      31 

as  concerns  the  ordinary  practice  of  the  art.  The  system 
does  attempt  to  show  the  status  of  the  business,  but  breaks 
down  at  one  point ;  where  a  mixed  account  such  as  an  ordi- 
nary merchandise  account  is  kept.  As  purchasers  are  deb- 
ited in  this  account  at  cost,  while  sales  are  credited  at  sell- 
ing prices,  it  necessarily  follows  that  the  balance  shown  by 
the  account  at  any  time  represents  the  value  of  the  mer- 
chandise still  on  hand,  less  the  profit  on  goods  sold  or  plus 
the  loss  on  goods  sold.  To  the  extent  that  such  accounts 
appear  the  system  is  not  self-sufficient,  and  the  essential 
needed  is  supplied  by  a  process  somewhat  outside  of  the 
bookkeeping  itself— that  is,  the  inspection  of  merchandise 
and  the  making  of  an  inventory.  Or,  granting  that  the 
inventory  is  part  of  the  double  entry  system,  it  still  remain* 
true  that  the  books  do  not  at  any  given  moment  show  the 
status  of  the  business.  When  that  is  desired  the  labor  of 
making  a  new  inventory  must  be  performed. 

Nor  is  it  true  that  any  set  of  books  ever  devised  shows 
with  perfect  accuracy  the  state  of  the  business  even  with 
the  addition  of  a  merchandise  inventory.  Inventories,  at 
best,  are  approximate,  and  it  will  be  shown  later  there  are 
points  of  principle  in  the  taking  of  inventories  on  which 
the  best  authorities  are  still  in  dispute.  Nor  is  it  possible 
always  to  determine  the  exact  nature  of  a  business  transac- 
tion so  as  to  secure  its  correct  entry  in  the  books  of  account. 
A  railroad,  for  instance,  replaces  an  old  wooden  bridge, 
costing  when  constructed  five  years  before  $500,  with  a 
new  steel  structure  costing  $2,500.  It  is  evident  that  the 
$2,500  expended  is  in  part  an  expense  (that  is,  a  charge  to 
some  Proprietorship  account),  and  in  part  an  exchange 
transaction  (that  is,  an  exchange  of  the  asset  "  cash  "  for 
another  asset,  "  steel  girders  ").  But  there  is  absolutely 
no  way  of  determining  the  exact  apportionment  of  charges 
between  these  diametrically  different  accounts.  Each  rail- 
road may,  it  is  true,  adopt  a  rule  of  thumb  which  it  follows 


32  MODERN   ACCOUNTING 

faithfully,  and  which,  at  times  is  dignified  with  the  title 
of  "  Principle  of  Accounting."  But  all  confess  it  is  still 
an  approximation,  and  the  fact  that  in  railroad  account- 
ing, where  the  system  is  most  elaborated  of  any  business 
enterprise,  the  directors,  from  time  to  time,  make  correct- 
ing entries  of  enormous  sums,  implies  that  either  before 
or  after  the  correction  the  accounts  were  in  essence  incor- 
rect, and  that  the  system  in  reality  broke  down.1 

Furthermore  double  entry  bookkeeping,  as  practiced 
does  not  even  attempt  to  show  the  actual  condition  of  the 
business,  in  that  to  a  large  extent  it  ignores  contingent 
liabilities.  Even  where  the  law  prescribes  a  statement  of 
such  liabilities,  as  is  the  case  in  British  companies,  it  is  to 
be  noticed  that  the  statement  of  contingent  liabilities  is 
merely  appended  to  the  Balance  sheet,  and  not  at  all  a 
part  of  it 2 — that  is,  they  are  no  part  of  the  bookkeeping 
system  of  the  company.  Occasionally  certain  contingent 
liabilities  are  booked,  as  for  instance  "  Bills  Rediscount- 
ed  "  in  the  statements  of  the  National  Banks  of  the  United 
States,  but  in  no  complicated  system  of  accounts  is  there 
any  effort  to  bring  into  the  books  all  the  contingent  liabili- 
ties and  thus  to  present  a  full  picture  of  the  real  status  of 
the  business.  Double  entry  bookkeeping  thus  being  not 
self-sufficient  as  a  system,  dealing  with  approximations 
rather  than  certainties,  and  presenting  only  a  partial  view 
of  the  facts  it  attempts  to  record,  does  not  deserve  the 
eulogium  of  Van  de  Linde  who  declares  "  Bookkeeping  is 
a  science  perfect  in  itself. ' '  Much  more  correct  is  the  mod- 

1  An  example  of  such  a  procedure  is  found  in  the  reports  of  the 
C.  &  N.  W.  R.  Co.  which  in  the  fiscal  year  1898-9  deducted  an  even 
$5,000,000  from  the  cost  of  the  road  charging  the  same  to  the  income 
account.  While  such  conservative  action  is  highly  praised  by  financial 
critics,  it  must  be  admitted  either  that  it  is  a  direct  violation  of  book- 
keeping principles,  or  that,  even  in  one  of  the  best  managed  roads,  the 
accounting  system  broke  down  and  had  to  be  patched. 

*  See  model  form  given  on  page  66. 


DOUBLE   ENTRY   BOOKKEEPING  33 

erate  statement  of  Rehm  that  the  "  principle  of  truthful- 
ness in  accounting  is  only  relative  and  limited." 


BIBLIOGRAPHICAL  NOTE  TO  CHAPTERS  I  AND    II 

CARLILL,  J.  A.     Principles  of  Bookkeeping.     London,  1896. 

CAYLEY,  A.     The  Principles  of  Bookkeeping.     Cambridge,  1894. 

DYER,  S.  A  Common  Sense  Method  of  Double  Entry  Bookkeeping 
on  First  Principles  as  Suggested  by  De  Morgan.  Part  I. 
Theoretical.  London,  1897. 

FOSTER,  B.  F.     Double  Entry  Elucidated.     Boston,  1852. 

HUGLI,  F.     Buchhaltungsstudien.     Bern,  1900. 

JONES,  THOMAS.  The  Principles  and  Practice  of  Bookkeeping. 
New  York,  1841. 

LISLE,  GEORGE.  Accounting  in  Theory  and  Practice.  Edinburgh, 
1906.  [This  is  perhaps  the  best  single  volume  treating  the 
entire  subject  which  has  appeared  in  English.] 

SCHAER,  J.  F.  Versuch  einer  wissenschaftlichen  Behandlung  der 
Buchhaltung.  Basel,  1890.  [In  this  treatise  is  presented  the 
theory  of  bookkeeping  on  which  Chapter  I  is  based.] 

SPRAGUE,  C.  E.  The  Philosophy  of  Accounts.  New  York,  1908. 
[The  most  important  theoretical  work  which  has  appeared  in 
English.] 

TIPSON,  F.  S.  The  Theory  of  Accounts.  New  York,  1902.  [Con- 
tains answers  to  the  questions  on  Theory  of  Accounts  given  in 
the  New  York  examinations  for  Certified  Public  Accountants.] 

The  following  reference  works  are  also  valuable: 

The  American  Business  and  Accounting  Encyclopaedia.  Detroit. 
Third  Edition,  1901.  [A  comprehensive  work  of  somewhat 
mixed  character.] 

DAWSON,  S.  S.  Accountant's  Compendium.  Third  Edition. 
London,  1908.  [A  valuable  reference  work  in  dictionary 
form.] 

Encyclopaedia  of  Accounting.  Edited  by  George  Lisle.  8  vols. 
Edinburgh,  1903-8.  [A  most  valuable  work  of  highest  scien- 
tific standard.] 


34  MODERN   ACCOUNTING 

STERN,  R.  Buchhaltungs  Lexikon.  Wien,  1904.  [The  repre- 
sentative German  work,  but  less  comprehensive  in  its  charac- 
ter.] 

Useful  text-books  of  bookkeeping  without  especial  reference 

to  theory  are: 

BOGLE,  A.  M.  Comprehensive  Bookkeeping.  New  York,  1905. 
[An  admirable  little  work  giving  good  exercises  free  from  ex- 
cessive arithmetical  detail.] 

DICKSEE,  L.  R.  Bookkeeping  for  Accountant  Students.  Fifth 
Edition.  London,  1906. 

Advanced  Accounting.    Third  Edition.    London,  1908. 

[The  above  two  works  form  a  comprehensive  treatise.  The 
latter  contains  an  admirable  collection  of  bookkeeping 
problems.] 

On  the  History  of  Bookkeeping,  with  an  extensive  bibliography 

of  the  subject,  see : 

BROWN,  R.  A  History  of  Accounting  and  Accountants.  Edin- 
burgh, 1905. 


CHAPTER    III 


THE   BALANCE   SHEET 

A  LEDGER  kept  according  to  the  principles  of  double 
entry  bookkeeping  will  at  any  time  show  various  accounts 
in  each  of  which  may  appear  sundry  Debit  and  Credit 
items.  A  list  of  the  totals  of  the  items  shown  in  each  ac- 
count gives  such  a  Trial  Balance  of  footings  as  is  shown  in 
column  (&)  below: 

FORM  17. 


(a) 
«        Title  of  Account. 

(6) 
Footings. 

Dr.                 Cr. 

(c) 
Balances. 

Dr.              Cr. 

Cash  

$9,000 
22,000 
15,000 
2,000 
150 
1,500 
10 
550 

$8,000 
21,000 
3,000 
7,000 

100 
110 
11,000 

$1,000 
1,000 
12,000 

150 
1,400 

$5,000 

100 
10,450 

Merchandise  

Bills  Receivable            

Bills  Payable.  .  .  ,  

Rent     

General  Expenses  

Commissions     

Proprietor's  Account  

$50,210 

$50,210 

$15,550 

$15,550 

The  characteristic  feature  here  is  that  the  total  Debits 
of  necessity  equal  the  total  Credits.  Such  a  balance  of 
footings  is  chiefly  valuable  as  furnishing  strong,  though 
not  conclusive  evidence  that  entries  have  been  correctly 
posted.  As  an  exhibit  of  the  status  of  the  concern  it  is 
made  more  lucid  if,  instead  of  the  total  footings,  only  the 
excesses  of  one  side  over  the  other  are  listed,  thus  forming 
a  Trial  Balance  of  Balances,  as  column  (c)  is  somewhat 
loosely  termed.  In  this,  too,  the  total  Debits  necessarily 
4  35 


36  MODEKN  ACCOUNTING 

equal  the  total  Credits  as  the  smaller  of  each  pair  of  items 
has  been  subtracted  from  each  column,  and  the  sum  of 
$34,660  being  thus  taken  from  equals  leaves  equal  remain- 
ders. 

Such  a  Balance  must  exist  at  any  time  in  books  which 
are  free  from  errors.  But  as  books  are  kept,  though  they 
must  at  any  time  thus  balance,  the  statement  which  is 
made  by  the  Trial  Balance  would  ordinarily  be  incorrect 
in  matter  and  incomplete  in  form.  Incorrect  in  matter 
because  of  the  presence  of  mixed  accounts,  such  as  the 
merchandise  account,  which  give  the  excess  of  Credits  over 
Debits  but  do  not  indicate  the  value  of  merchandise  on 
hand,  nor  exhibit  the  profit  on  goods  sold.  Assuming  in 
the  case  given  that  an  inventory  shows  the  merchandise  to 
be  worth  $4,000  there  is  an  error  of  $3,000  which  must  be 
adjusted  both  in  the  Merchandise  and  in  some  Proprietor- 
ship account,  normally  by  crediting  Profit  and  Loss. 
There  may  also  be  further  inaccuracies  because  other  ac- 
counts show  only  the  amount  of  expenses  paid  or  profits 
received  and  not  the  total  incurred  or  accrued.  Thus  the 
amount  of  interest  or  rent  appearing  in  the  books  does  not, 
except  by  chance,  indicate  the  charges  actually  incurred 
during  the  period  covered  by  the  accounts,  but  merely  the 
amount  which  has  been  paid,  which  may  be  either  greater 
or  less  than  the  amount  properly  chargeable  to  Profit  and 
Loss.  In  the  case  given  it  may  be  assumed  that  the  rent 
item  of  $150  was  for  six  months;  but  that  at  the  time  of 
balancing  three  months  more  have  elapsed  on  which  rent 
is  accrued  but  not  yet  paid,  so  that  there  is  altogether  $225 
rent  chargeable  against  the  profits  of  the  period.  This 
simple  illustration  is,  of  course,  capable  of  the  widest  ex- 
tension, for  in  a  large  concern  the  unadjusted  accounts  are 
frequently  of  decided  importance. 

The  Trial  Balance  is  incomplete  in  form  because  it 
shows  several  items  indicating  profit  or  loss,  and  these  have 


THE   BALANCE   SHEET 


37 


not  been  combined  into  a  single  account,  so  as  to  present 
the  facts  in  a  way  easily  to  be  understood.  A  Trial  Bal- 
ance fails  to  concentrate  the  various  temporary,  subsidiary 
accounts  which  indicate  changes  in  Proprietorship.  This 
must  be  done  by  closing  these  accounts  into  the  Profit  and 
Loss  Account  which  then  shows : 


Dr. 


FORM  18. 
Profit  and  Loss. 


Cr. 


General  Expenses $1,400 

Rent 225 

Balance 1,475 

$3,100 


On  Merchandise  Sales $3,000 

Commissions 100 


$3,100 
Balance...  ..$1,475 


If  the  changes  here  indicated  are  made  in  the  ledger 
there  then  results  a  true  Balance  Sheet  which  may  be  pre- 
sented in  the  following  form: 


Dr. 


FORM  19. 
Balance  Sheet. 


Cr. 


Cash $1,000 

Merchandise 4,000 

Bills  Receivable 12,000 

$17,000 


Bills  Payable $5,000 

Rent  Due 75 

Proprietor's  Account 11,925 

$17,000 


The  Balance  Sheet  then  differs  from  a  mere  Trial  Bal- 
ance in  that  correct  figures  have  been  introduced  through 
the  inventory  and  the  subsidiary,  temporary  accounts  have 
all  been  gathered  together  and  combined  with  the  more 
permanent  Proprietorship  account.  In  the  instance  given 
here  all  is  combined  in  one  Proprietor's  account,  as  is 
customary  in  the  accounts  of  private  traders.  Where  a 
corporation  is  concerned  the  net  profits  are  not  added  to 


38  MODERN  ACCOUNTING 

the  Capital  account,  but  may  be  stated  in  a  single  credit 
to  Profit  and  Loss,  or  perhaps  by  credits  to  Surplus,  Re- 
serve, etc.,  as  shown  in  later  chapters. 

The  gathering  together  of  all  the  changes  in  net  wealth 
and  their  condensation  into  one  account  presumably  takes 
place  in  the  ledger  itself  as  well  as  in  the  statement  known 
as  the  Balance  Sheet.  It  is  done  by  transferring  the  bal- 
ance formerly  standing  to  the  debit  of  Expense  to  Profit 
and  Loss;— that  is,  by  Debiting  the  latter  and  Crediting 
the  former  account.  Similarly  with  the  other  accounts 
concerned,  and  finally  the  balance  showing  in  Profit  and 
Loss  is  itself  transferred  by  an  identical  process  to  the 
Proprietor's  account.  When  this  is  done  a  trial  balance 
taken  from  the  ledger  corresponds  exactly  with  the  Bal- 
ance Sheet  given  above.  There  are  no  longer  any  balances 
standing  to  temporary  accounts;  there  are  no  longer  any 
incorrect  balances  due  to  the  inclusion  of  mixed  accounts. 
But  this  condition  is  but  momentary  and  as  soon  as  trans- 
actions are  again  recorded  the  Trial  Balance  no  longer 
presents  a  statement  at  once  correct  and  condensed.  But 
it  is,  of  course,  possible  to  prepare  a  Balance  Sheet  from 
the  data  obtained  from  the  ledger,  supplemented  with  an 
inventory  or  other  estimate  of  values,  without  making  the 
changes  in  the  ledger  accounts. 

The  condensation  and  combination  shown  in  the  Balance 
Sheet  given  above  applied  only  to  Proprietorship  accounts. 
A  somewhat  similar  grouping  of  the  accounts  representing 
Goods,  both  positive  and  negative,  may  be  performed  for 
the  purpose  of  making  the  showing  of  the  Balance  Sheet 
more  perspicacious.  Thus  the  ledger  may  contain  a  num- 
ber of  different  accounts  of  individuals  who  are  debtors. 
It  were  foolish  to  list  these  individually  in  the  Balance 
Sheet  and  so  they  may  be  subsumed  under  the  title  Ac- 
counts Receivable,  although  in  the  ledger  each  debtor  has 
a  separate  account.  Or  a  bank,  while  carefully  distin- 


THE   BALANCE   SHEET  39 

guishing  in  its  own  books  between  the  amounts  deposited 
with  each  of  its  several  correspondents,  in  its  Balance 
Sheet  may  not  only  combine  these  but  may  write  them  with 
the  actual  cash  on  hand  under  the  single  title  "  Cash  on, 
hand  and  on  deposit."  The  Balance  Sheet  then  not  only 
shows  a  statement  condensed  to  .correspond  to  the  ledger 
after  that  has  been  altered  by  the  changes  periodically  in- 
troduced, but  may  go  further  in  the  process  of  condensa- 
tion combining  accounts  which  are  kept  separate  in  the 
ledger. 

To  sum  up :  A  ledger  as  kept  from  day  to  day  shows 
both  Debits  and  Credits  in  both  permanent  and  temporary 
accounts,  and  contains  incorrect  amounts  in  the  mixed  ac- 
counts, and  unadjusted  accounts  such  as  "  Interest  Pay- 
able." A  trial  balance  of  these  footings,  or  of  the  balances 
would  indicate  whether  the  book  as  a  whole  balanced,  but 
would  give  a  poor  survey  of  the  condition  of  the  concern, 
To  make  a  clearer  exhibit  there  should  be  a  consolidation 
of  accounts,  a  correction  of  the  mixed  accounts  by  the  in- 
troduction of  the  inventory,  an  adjustment  of  accruing 
expenses  and  income,  a  closing  of  the  subsidiary  accounts 
into  the  general  Profit  and  Loss  account.  A  list  of  the 
ledger  balances  after  this  has  been  done  would  be  a  Bal- 
ance Sheet.  But  in  the  approved  form  still  greater  sim- 
plicity may  be  secured  by  grouping  together  similar  items 
and  the  cancellation  of  certain  positive  and  negative  items 
even  where  these  processes  are  not  performed  in  the  ledger. 

In  the  preceding  chapter  was  sketched  the  development 
of  a  scheme  of  accounts  from  an  ideally  simple,  but  un- 
serviceable set  of  three  accounts,  to  one  which  by  the 
division  and  subdivision  of  different  classes,  and  the  sepa- 
ration of  the  Debit  and  Credit  sides  of  a  single  account 
into  independent  accounts,  secures  a  mass  of  detail  neces- 
sary to  the  thorough  understanding  of  the  business  oper- 
ations. The  formation  of  the  Balance  Sheet  is  the  reverse 


40  MODERN   ACCOUNTING 

process.  From  a  mass  of  details  in  which  the  forest  is 
hidden  by  the  trees,  there  is  prepared  by  synthesis  and 
simplification  a  statement  in  which  the  main  facts  are  pre- 
sented succinctly  and  intelligibly.  The  process  of  differ- 
entiation and  integration  has  no  fixed  limit.  It  is  carried 
on  so  long  as  it  proves  economically  justifiable.  The  re- 
verse process  involved  in  the  preparation  of  a  Balance 
Sheet,  similarly  has  no  absolute  limit.  For  its  daily  rou- 
tine, a  bank,  for  instance,  needs  to  have  accounts  showing 
the  amount  due  to  each  individual;  for  other  purposes  it 
may  desire  to  show  separately  its  "  Savings  deposits,"  its 

41  Time  Certificates,"  its  "  Checking  Accounts,"  etc.,  for 
still  others  a  single  item  "  Amount  due  Depositors  "  suf- 
fices. The  purpose  for  which  the  Balance  Sheet  is  prepared 
determines  the  extent  to  which  condensation  is  to  be  car- 
ried and  the  form  in  which  it  is  to  be  presented. 

The  advantages  of  the  Balance  Sheet  being  obvious,  it 
seems  strange  that  its  use  was  so  long  delayed.  In  the 
earliest  treatises  the  taking  of  even  a  trial  balance  of  foot- 
ings was  not  suggested  as  a  means  of  verifying  the  correct- 
ness of  postings.  That  was,  done  by  carefully  checking 
«ach  Debit  entry  with  its  corresponding  Credit  and  when 
everything  checked  off  the  ledger  was  assumed  to  be  cor- 
rect. Nor  were  the  ledgers  balanced  at  regular  or  frequent 
intervals.  Of  early  account  books  still  extant  one  was  not 
balanced  at  all  in  nine  years,  another  not  until  the  end  of 
twenty-seven  years.  Early  trading  being  largely  of  the 
nature  of  separate  ventures,  the  sending  of  a  caravan  to 
one  place  or  a  ship  to  another,  profits  were  reckoned  sepa- 
rately on  each  completed  venture.  But  those  still  uncom- 
pleted, the  ships  not  yet  come  in,  were  left  out  of  account. 
Hence  it  was  not  necessary  to  balance  the  ledger  as  a 
whole,  and  the  practice  recommended  by  Paciolo  of  bal- 
ancing only  when  a  new  book  was  opened  seems  to  have 
been  generally  followed  by  trading  companies.  The  Brit- 


THE   BALANCE   SHEET  41 

ish  East  India  Company  prepared  a  general  balance  in 
1665,  but  not  again  until  1685.  The  French  ordonnance  of 
1673,  however,  required  an  inventory  and  Balance  Sheet 
each  two  years  and  in  a  treatise  by  Schurtz  in  1695  a  quar- 
terly balancing  of  the  ledger  is  inculcated. 

In  recent  times  the  preparation  of  an  annual  Balance 
Sheet  is  nearly  universal.  It  is  required  by  law  in  Eng- 
land, France,  Germany,  and  other  countries  of  all  corpo- 
rations. And  while  in  the  United  States  there  are  few 
legal  requirements  in  regard  to  the  form  of  accounts,  yet 
certain  classes  of  corporations  which  are  regulated  by  law, 
such  as  banks,  insurance  companies,  and  public  utility 
companies,  frequently  are  required  to  submit  statements 
including  Balance  Sheets  to  state  or  federal  officials.  The 
Interstate  Commerce  Commission,  under  authority  of  the 
amended  law  of  1906,  has  prepared  a  form  for  the  Balance 
Sheet  to  which  all  railroads  under  their  supervision  must 
conform.  A  Balance  Sheet  in  this  form  is  given  on  page  59. 
The  Massachusetts  business  corporation  law  of  1903  also 
provides  a  form  of  Balance  Sheet  to  be  annually  prepared 
by  all  corporations  within  the  State. 

A  Balance  Sheet  being  a  summary  of  the  ledger  must 
contain  two  groups  of  figures,  showing  respectively  Debit 
and  Credit  balances.  Usually  these  two  groups  are  ar- 
ranged in  parallel  columns,  similar  to  the  conventional 
arrangement  of  a  ledger  account.  Indeed  in  earlier  days, 
and  even  to-day  in  continental  countries,  the  Balance  Sheet 
is  in  fact  a  ledger  account,  all  of  the  accounts  being  actu- 
ally closed  out  and  their  balances  transferred  to  a  "  Bal- 
ance Account  "  which,  of  course,  itself  balances.  When 
this  is  done  the  ledger  is  actually  closed,  no  outstanding 
balances  any  longer  appearing  to  the  Debit  or  Credit  of 
any  account.  English  and  American  bookkeepers  long  ago 
tired  of  the  useless  work  of  actually  closing  the  accounts 
in  the  ledger,  necessitating  as  it  does  the  immediate  re- 


42  MODERN  ACCOUNTING 

entering  of  the  items  in  new  accounts.  The  Balance  Sheet 
is  now  prepared  as  an  outside  abstract  of  the  ledger  rather 
than  as  an  actual  ledger  account. 

Some  confusion  is,  however,  caused  by  divergence  in 
practice  in  regard  to  the  relative  position  of  the  column 
containing  ' '  Asset  ' '  items  and  ' '  Capital  and  Liabilities  ' ' 
items  respectively.  The  general  custom  throughout  the 
world  is  to  place  the  asset  items  in  the  left  hand  column. 
But  in  England  the  reverse  is  customary,  and  asset  items 
appear  in  the  right  hand  column.  Much  discussion  has 
taken  place  on  this  point.  The  chief  argument  against  the 
English  custom  is  that  it  is  at  variance  with  the  practice  of 
the  rest  of  the  world,  even  Scottish  accountants  not  follow- 
ing the  English  model,  and  it  seems  also  to  be  at  variance 
with  common  sense,  that  a  summary  of  the  ledger  should 
reverse  the  accounts  from  the  position  which  they  hold  in 
the  ledger  itself.  On  the  other  hand  it  is  urged  in  sup- 
port of  the  English  practice  that  the  Balance  Sheet  is  not 
in  itself  a  summary  of  the  ledger  but  an  account  sub- 
mitted  by  the  company  or  by  the  directors  to  the  stock- 
holders, for  which  purpose  it  is,  of  course,  actually  pre 
pared.  As  such  it  is  logical  to  charge  the  directors  with 
the  capital  and  other  funds  furnished  to  the  company  and 
to  take  credit  for  the  assets  on  hand,  which  at  the  time  of 
the  report  are  constructively  tendered  to  the  stockholders 
in  satisfaction  of  the  account. 

The  extended  debate  on  the  subject  seems  largely  a 
logomachy,  and  doubtless  no  one  ever  was  misled  by  the 
divergence  in  practice.  Uniformity  is  however  desirable, 
and  even  among  British  accountants  there  is  much  opposi- 
tion to  this  national  idiosyncrasy.  "  The  custom  seems  to 
have  arisen,"  says  Lisle,  "  through  the  influence  of  the 
forms  given  in  Acts  of  Parliament,  chiefly  the  Companies 
Act,  1862,  which  must  have  been  prepared  by  those  unac- 
quainted with  the  theory  of  accounts.  The  Profit  and  Loss 


THE   BALANCE   SHEET  43 

Account  is  taken  from  the  Ledger,  and  the  sides  are  not 
transposed,  and  there  is  no  logical  reason  why  the  sides  in 
the  Balance  Sheet  should  be  reversed  when  the  items  in  it 
are  supposed  to  be  the  balances  remaining  in  the  Ledger, 
after  certain  balances  have  been  taken  to  the  Profit  and 
Loss  Account.  ...  It  is  certainly  most  desirable  that  the 
form  of  Balance  Sheet  with  the  assets  on  the  left  side  which 
is  founded  on  correct  principles,  should  become  universal, 
conforming  to  the  best  traditions  and  the  accepted  practice 
of  the  rest  of  the  world. ' ' 

Technically  expressed  the  difference  is  that  the  British 
Balance  Sheet  is  the  opening  balance  account,  while  the 
rest  of  the  world  uses  the  ' '  closing  balance  ' '  account.  As 
shown  above,  in  the  formal  method  of  balancing,  all  ac- 
counts are  closed  into  a  balance  account  on  the  debit  side 
of  which  appear  the  debit  balances  of  the  various  ledger 
accounts.  But  in  this  system  the  accounts  must  imme- 
diately be  reopened,  which  is  also  done  by  means  of  a  Bal- 
ance Account,  the  "  Opening  Balance."  The  new  asset 
accounts,  "  Cash,"  "  Merchandise,"  etc.,  being  debited 
with  the  outstanding  balances,  a  corresponding  credit  is 
made  in  the  Balance  Account,  which  evidently  is  identical, 
save  that  the  sides  are  reversed,  with  the  "  Closing  Bal- 
ance "  account.  But  it  is  difficult  to  find  any  logical  pref- 
erence for  the  account  showing  the  opening  of  the  new 
year  over  that  showing  the  momentarily  antecedent  closing 
of  the  old  year. 

Still  further  divergence  exists  in  regard  to  the  title  to 
be  given  the  two  sides  of  the  balance  sheet.  That  contain- 
ing the  assets  is  frequently  headed  "  Assets  "  or  "  Re- 
sources." The  other  side  has  perhaps  most  frequently 
been  entitled  "  Liabilities."  To  this  much  criticism  has 
been  made  on  the  ground  that  the  Capital  or  Proprietor- 
ship accounts,  which  in  many  cases  are  the  most  important 
are,  strictly  speaking,  not  liabilities  of  the  company,  still 


44  MODERN   ACCOUNTING 

less  of  the  individual  proprietor.    To  avoid  this  difficulty 
the  title  "  Capital  and  Liabilities  "  is  often  used. 

Other  accountants  prefer  to  head  the  two  sides  Debit 
and  Credit,  as  an  ordinary  ledger  account  or  account  cur- 
rent is  headed.  But  the  application  of  the  terms  Debit 
and  Credit  offers  an  additional  difficulty  where  the  Eng- 
lish form  of  Balance  Sheet  is  adopted.  It  is  a  well-nigh 
inviolate  convention — (but  only  a  convention  and  not,  as 
claimed  by  many  writers,  a  principle) —of  double  entry 
bookkeeping,  that  the  left  hand  column  is  called  "  debit." 
But  another  sacred  convention  is  that  assets  are  ' '  debits. ' ' 
When  he  finds  the  assets  in  the  right  hand  column  the  ac- 
countant is  indeed  perplexed.  Shall  the  right  hand  column 
be  called  Credit  because  of  its  position  or  Debit  because 
of  its  content  ?  Practice,  for  here  as  elsewhere  in  account- 
ing there  is  no  absolute  authority,  varies.  Thus  the  head- 
ings and  position  of  the  two  columns  of  this  most  impor- 
tant accounting  form,  show,  in  good  usage,  the  following 
variations : 

Assets  Liabilities 

Resources  Liabilities 

Liabilities  Resources 

Liabilities  Assets 

Debit  (Assets)  Credit  (Liabilities) 

Debit  (Liabilities)  Credit  (Assets) 

Credit  (Liabilities)  Debit  (Assets) 

Active  Passive. 

It  thus  appears  that  there  is  not  merely  divergent  usage 
as  to  the  position  of  the  asset  items,  but  that  these  assets 
are  sometimes  called  Debits  and  sometimes,  as  for  instance 
in  the  Balance  Sheet  of  the  Bank  of  France,  Credits,  and 
sometimes  the  first  column  not  only  contains  the  liabilities 
but  is  labeled  Credit. 

The  headings  "  Active  "  and  "  Passive  "  deserve  fur- 


THE   BALANCE'  SHEET  45 

ther  mention.  They  are  given  to  the  two  sides  of  the  Bal- 
ance Sheet  by  practically  all  the  world  except  the  English 
speaking  peoples.  Reason  as  well  as  custom  gives  prefer- 
ence to  them  over  the  other  simple  descriptive  titles,  .for 
the  one  side  of  the  Balance  Sheet  sometimes  contains  items 
which  are  not  assets  or  resources  while  the  other  side 
always  contains  items  which  are  not  liabilities,  and  fre- 
quently includes  those  that  are  neither  liabilities  nor 
capital.  Debit  and  Credit  too  are  undesirable  as  being 
technical  but  not  significant.  English  and  American  ac- 
countants have  nevertheless  been  loath  to  adopt  this  better 
nomenclature.  It  is  recommended  by  Sprague  in  his  val- 
uable treatise  "  The  Accountancy  of  Investment,"  but  it 
is  practically  unknown  in  balance  sheets  published  in  the 
United  States. 

A  slight  variation  in  the  forms  given  above  consists  in 
using  the  phrase  "  Capital  and  Liabilities  "  in  place  of 
the  single  word  Liabilities  to  designate  one  side  of  the 
Balance  Sheet.  By  many  accountants  this  is  considered 
an  important  improvement.  It  certainly  has  the  advan- 
tage of  more  completely  describing  the  contents  of  the 
column,  and  removes  the  confusion  which  arises  from 
treating  the  proprietors'  capital  as  though  it  were  legally 
a  liability. 

As  the  Balance  Sheet  is  designed  to  give  an  intelligent 
synopsis  of  the  business  it  is  evidently  advantageous  not 
only  to  consolidate  ledger  accounts  of  an  identical  nature 
into  a  single  collective  account,  as  the  sums  due  from  vari- 
ous customers  are  subsumed  under  the  title  "  Accounts 
Receivable  "  but  also  to  group  the  various  items,  which 
while  differing  enough  to  be  kept  separate,  have  certain 
similar  characteristics.  Thus  while  Accounts  Payable  and 
Bills  Payable  are  separately  shown  it  adds  to  clearness  to 
have  them  appear  near  each  other  in  the  Balance  Sheet. 

Subheads    are    frequently    introduced    into    Balance 


, 


46  MODEKN   ACCOUNTING 

Sheets  to  make  more  clear  the  grouping  of  items.  The 
particular  terms  thus  used  vary  according  to  the  taste  of 
the  accountant  and  the  nature  of  the  corporation.  In  a 
grpuping  coming  into  considerable  use  the  headings  are: 
Capital  Assets,  Current  Assets,  and  Deferred  Assets,  with 
a  similar  division  of  liabilities.  By  Capital  Assets  is  here 
meant  the  permanent  plant  of  the  corporation,  presumably 
purchased  with  the  proceeds  of  the  Capital  Liabilities — 
that  is,  the  stock  and  bonds.  Current  Assets  are  cash, 
realizable  securities  and  accounts,  or  merchandise  or  mate- 
rial to  be  currently  consumed.  On  the  other  hand  Current 
Liabilities  are  those  that  are  not  permanent  or  funded. 
Deferred  assets  generally  represent  expenses  paid  in  ad- 
vance. Their  inclusion  among  assets  is  discussed  in  Chap- 
ter V.  This  classification  is  used  for  instance  by  the 
Chicago  and  Alton  Railway. 

The  grouping  of  similar  items  leads  to  the  marshaling 
of  the  entire  list  in  some  systematic  order.  This  is  espe- 
cially the  case  in  regard  to  the  assets,  where  the  system 
generally  used  is  based  on  the  degree  of  ease  with  which 
they  may  be  converted  into  cash;  or,  in  ether  words,  the 
assets  are  ranked  according  to  their  liquidity.  At  one  end 
of  the  scale  is  cash  in  which  liquidity  is  perfect,  on  the 
other  end  those  assets  which  cannot  be  realized  at  all 
while  the  business  continues  its  existence,  as  perhaps  the 
roadbed  of  a  railroad  or  the  good  will  of  a  factory.  But 
disagreements  appear  as  to  whether  the  proper  order  is 
from  liquid  assets  to  fixed,  or  from  fixed  to  liquid.  Stated 
concretely  the  question  is  whether  the  list  of  assets  should 
begin  or  end  with  cash. 

The  argument  in  favor  of  showing  Cash  first  among 
the  assets  is  perhaps  a  little  forced,  for  it  rests  on  the 
false  assumption'  that  cash  is  in  all  cases  the  most  impor- 
tant item.  It  is  true  that  in  some  institutions,  for  instance 
a  commercial  bank,  cash  on  hand  is  the  most  significant  of 


THE   BALANCE   SHEET  47 

the  assets,  showing  the  ability  of  the  bank  to  meet  a  sud- 
den run.  It  may  even  be  true  that  cash  is  generally  more 
important  than  any  other  item  of  similar  amount,  but  it 
seems  a  gross  perversion  to  say  that  in  a  railroad  the  rela- 
tively small  amount  of  cash  is  more  important  than  the 
great  fixed  plant.  Even  an  insurance  company  must 
surely  attach  more  importance  to  its  many  millions  of 
investments  than  to  its  cash,  for  unlike  a  bank  the  demands 
made  upon  an  insurance  company  are  such  as  to  give  time 
for  realization  of  assets.  Foreign  accounting  practice 
seems  to  recognize  the  varying  importance  of  cash  in  dif- 
ferent classes  of  institutions.  Thus  in  Austria  and  Ger- 
many the  Balance  Sheets  of  banks  very  generally  give 
cash  as  the  first  of  the  assets  while  in  those  of  industrial 
corporations  cash  appears  farther  down  the  list.  In  the 
United  States  and  England  n  the  contrary,  it  is  very 
unusual  to  find  cash  listed  nrst  either  by  banks  or  other 
corporations. 

Strict  consistency  compels  a  marshaling  of  the  liabil- 
ities similar  to  that  of  the  assets.  Convenience  of  inspec- 
tion certainly  demands  that  similar  assets  and  liabilities 
appear  opposite  each  other.  Cash  is  naturally  compared 
with  the  liabilities  on  which  immediate  payment  may  be 
demanded.  Yet  strangely  some  accountants  who  place 
cash  at  the  beginning  of  the  assets  do  not  change  the  con- 
ventional order  of  the  items  on  the  other  side  but  head 
the  list  with  the  permanent  item  Capital.  This  results  in 
the  juxtaposition  of  Cash  and  Capital  Stock,  items  which 
in  a  growing  concern  have  the  least  possible  connection 
with  each  other.  One  may,  perhaps,  not  insist  on  cash 
coming  first.  Even  in  a  bank  statement,  one  is  habituated 
to  look  at  the  last  item  as  the  most  significant  of  the  assets. 
But  certainly  strong  objection  is  to  be  made  to  having  a 
different  order  of  arrangement  on  the  two  sides  of  the 
balance*  sheet.  Occasionally  consistency  in  this  respect  is 


48 


MODERN   ACCOUNTING 


found  in  Balance  Sheets.  That  of  the  American  District 
Telegraph  Company  of  New  Jersey  may  be  mentioned,  in 
which  the  assets  run  from  Cash  to  Plant,  and  the  liabilities 
begin  with  Bills  Payable  and  end  with  Capital  and  Sur- 
plus. 

Another  variation  in  the  form  of  the  balance  sheet  is 
that  prescribed  for  the  so-called  parliamentary  companies 
of  England,  and  known  as  the  Double- Account  Balance 
Sheet.  An  example  is  as  follows: 


Dr. 


FORM  20. 
Capital  Account. 


Cr. 


Cost  of  property £195,000 

Balance 5,000 

£200,000 


Share  capital £100,000 

Debentures 100,000 

£200,000 


General  Balance  Sheet. 


Liabilities 


Assets 


Capital  account,  balance. .   £5,000 

Bills  payable 10,000 

Profit  and  loss 3,000 

£18,000 


Materials,  etc £4,000 

Cash 6,000 

Accounts  receivable 8,000 

£18,000 


It  is  to  be  noticed  that  the  Balance  Sheet  proper  does 
not  contain  the  entire  outstanding  capital  but  merely  the 
portion  of  the  capital  receipts,  including  receipts  from 
funded  debts,  which  have  not  been  expended  in  acquiring 
the  company's  plant.  Nor  does  the  Balance  Sheet  itself 
include  the  plant  in  the  asset  column.  Information  on 
these  points  is  gained  from  the  accompanying  capital  ac- 
count, the  balance  of  which  is  brought  down  as  a  liability 
in  the  General  Balance  Sheet. 

The  origin  of  this  peculiar  arrangement  is  that  the  law 


THE   BALANCE   SHEET 


49 


governing  such  companies  provides  that  the  money  re- 
ceived on  capital  account, — that  is,  from  subscription  to 
shares  or  from  sales  of  debentures,  etc.— may  be  used  solely 
for  investment  in  the  plant  of  the  company,  and  the 
Double  Account  Balance  Sheet  is  designed  to  show  how 
far  this  requirement  has  been  fulfilled.  This  form  is 
rarely  used  in  American  practice  but  it  has  practically 
been  adopted  in  the  reports  of  the  Atchison,  Topeka  and 
Santa  Fe  Railway,  as  shown  on  page  60. 

The  Balance  Sheet  of  the  company  given  above,  if  pre- 
sented in  the  ordinary  English  form,  would  be : 


FORM  21. 
Balance  Sheet. 


Capital  and  Liabilities 


Assets 


Share  capital .£100,000 

Debentures 100,000 

Bills  payable 10,000 

Profit  and  loss 3,000 

,£213,000 


Cost  of  property £195,000 

Materials,  etc 4,000 

Accounts  receivable 8,000 

Cash 6,000 

£213,000 


In  discussing  the  subject  of  the  shrinkage  in  value  of 
plant  in  reference  to  profits  it  will  be  shown  that  the 
double  account  form  of  Balance  Sheet  has  had  a  consider- 
able and  perhaps  baleful  influence  on  the  legal  interpreta- 
tion of  accounts.  It  has  indeed  been  argued  that  the 
placing  of  the  capital  in  a  separate  account  involves  the 
principle  that  changes  therein  cannot  affect  the  Profit  and 
Loss  account  appearing  in  the  Balance  Sheet.  While  the 
validity  of  this  inference  may  be  questioned  it  is  true  that 
the  isolation  of  "  capital  assets  "  and  "  capital  liabil- 
ities ' '  in  the  capital  account  has  a  tendency  to  cause  them 
to  be  considered  as  isolated  in  fact,  and  has  led  to  some 
far-reaching  conclusions  which  might  otherwise  never  have 
been  reached. 


50  MODERN   ACCOUNTING 

Another  question  relating  to  the  form  of  the  Balance 
Sheet,— namely,  whether  certain  items  are  better  shown  as 
additions  on  one  side  or  as  subtractions  on  the  other  side 
is  of  considerable  practical  importance.  This  can  best  be 
considered  after  a  discussion  of  the  nature  of  the  various 
classes  of  accounts  found  on  either  side  of  the  balance 
sheet. 

On  the  Debit  side  are  found  the  following: 

1.  Assets,  of  whatever  kind  and  including  whatever 
subdivisions  such  as  capital  assets,  circulating  assets,  im- 
material assets,  etc. 

2.  Loss — when  the  business  shows  a  net  deficiency. 

3.  Debit  Valuation  Accounts. 
On  the  Credit  Side :  " 

4.  Capital— in  the  strict  sense  of  the  contributions  made 
by  stockholders  or  proprietors. 

5.  Profits — in  the  broad  sense  of  the  accumulations  or 
accretions  to  the  original  capital,  which  may  be  divided 
into  various  subheads,  such  as  Surplus,  Reserve,  Undivided 
Profits,  etc. 

6.  Liabilities  in  the  strict  sense  of  debts  due  by  the 
business. 

7.  Credit  Valuation  Accounts. 

Of  the  above  groups,  (1)  and  (6)  are  easily  identified 
as  "  Goods  "  accounts,  positive  and  negative  respectively, 
while  (4),  (5)  and  (2)  are  Proprietorship  accounts,  the 
last  named  negative,  the  others  positive. 

These  are  already  familiar,  but  the  remaining  groups,. 
(3)  and  (7)  require  further  description.  These  accounts 
may  be  called  Valuation  Accounts,  adopting  the  German 
nomenclature  (Bewertungskonten)  as  there  is  no  well  es- 
tablished English  term.  They  may  be  defined  as  accounts 
introduced  for  the  technical  purpose  of  indicating  that  a 
sum  is  to  be  subtracted  from  some  other  account.  Alge- 
braically they  correspond  to  a  negative  item  transferred 


THE   BALANCE   SHEET  51 

to  the  other  member  of  the  equation  with  a  transformation 

of  sign.    Thus  in  the  equation : 

^ 

4x  —  2x  =  5y  —  iy 

the  terms  2x  and  4y  are  evidently  to  be  subtracted  from 
4x  and  5y  respectively.  But  the  equation  is  still  correct 
if  it  is  presented  in  the  form 

4x  +  4y  =  5y  +  2x 

in  which  4y  and  2x  would  correspond  to  a  Debit  and  a 
Credit  Valuation  account,  respectively.  They  represent, 
therefore,  not  independent  values  but  merely  that  a  sum 
is  to  be  subtracted  from  another  item  purposely  overstated 
on  the  other  side  of  the  equation. 

This  is  quite  in  consonance  with  practice  already  ex- 
plained. It  has  been  seen  that  expense  is  logically  a  sub* 
traction  to  be  made  ultimately  from  the  proprietor's  Cap- 
ital account,  or  immediately  from  Profit  and  Loss.  But 
instead  of  entering  every  expense  item  at  once  to  the 
debit  of  Profit  and  Loss,  it  is  placed  temporarily  in  a  spe- 
cial Expense  Account.  But  these  negative  Proprietorship 
accounts  are  ordinarily  temporary.  Before  the  prepara- 
tion of  the  final  Balance  Sheet  they  disappear  by  being 
included  with  other  items  in  the  general  Profit  and  Loss 
account.  But  so  long  as  a  balance  stands  to  the  debit  of 
Expense,  it  indicates  that  to  that  extent  the  showing  made 
in  the  Profit  and  Loss  or  in  the  Proprietor's  account  is 
incorrect,  that  it  is  overstated  because  a  necessary  subtrac- 
tion has  not  yet  been  made.  Valuation  accounts  are  sim- 
ilar in  origin  and  purpose  but  differ  in  being  more  perma- 
nent in  character. 

The  simplest  and  best  type  of  a  Valuation  account  is 
the  Depreciation  account.  At  the  beginning  of  the  year  a 
concern  buys  machinery  for  $10,000.  This  is  properly 
debited  to  the  Machinery  account,  and  is  listed  among  the 


52 


MODERN   ACCOUNTING 


assets.  But  during  the  year  the  value  of  the  machinery 
declines  because  of  wear  and  tear.  The  machinery  in- 
stead of  being  worth  $10,000  as  shown  by  the  account  is 
worth  only  $9,000.  Correct  accounting  demands  that  this 
change  be  shown  just  as  much  as  that  a  payment  of  $1,000 
out  of  the  cash  balance  of  $10,000  be  shown.  The  simplest 
and  most  direct,  but  not  necessarily  the  best  way  of  show- 
ing this  decline  is  to  enter  the  $1,000  depreciation  in  the 
Credit  side  of  the  Machinery  account  thus  reducing  the 
effective  balance  to  $9,000.  But  it  is  also  permissible  to  do 
here  what  was  done  in  regard  to  Expense— that  is,  to  indi- 
cate the  required  deduction  not  by  immediate  entry  in  the 
minuend  account  but  by  establishing  an  independent  ac- 
count for  the  subtrahend.  In  this  case  instead  of  showing 
the  account  thus : 


Dr. 


FORM  22. 
Machinery  Account. 


Cr. 


Cost  price $10,000 


$10,000 
Balance  brought  down. .  .    $9,000 


Depreciation $1,000 

Balance 9,000 

$10,000 


the  ledger  shows  the  following  two  accounts: 


Dr. 


FORM  23. 
Machinery  Account. 


Cr. 


Cost  price $10,000 


Dr. 


Depreciation  Account. 


Cr. 


On  machinery $1,000 


THE   BALANCE   SHEET 


53 


The  resemblance  of  such  accounts  to  the  Expense  and 
other  Negative  Proprietorship  accounts  is  clear.  But  while 
the  Expense  account  disappears  from  the  ledger  at  the 
end  of  the  year,  when  it  is  closed  into  Profit  and  Loss,  the 
Valuation  accounts  continue  beyond  the  period  for  closing 
the  ledger.  It  is  not  for  years,  and  perhaps  never,  closed 
into  the  account  from  which  it  indicates  a  subtraction. 
As  a  balance  showing  on  the  ledger  it  must  therefore  be 
considered  when  the  formal  Balance  Sheet  is  prepared. 
Debit  Valuation  Accounts  are  similar  in  their  nature,  but 
of  course,  indicate  a  subtraction  to  be  made,  from  some  item 
standing  on  the  Liabilities  side  of  the  Balance  Sheet.  An 
item  representing  unissued  stock  or  bonds,  or  showing  a 
discount  on  the  issue  of  capital  stock,  will  serve  as  an  ex- 
ample of  such  an  account. 

The  question  of  form  to  which  reference  was  made 
above,  concerns  the  treatment  of  these  Valuation  Ac- 
counts. The  point  at  issue  is  whether  Valuation  Accounts 
should  appear  in  the  Balance  Sheet  as  independent  items, 
or  whether  the  subtraction  which  they  are  designed  to 
indicate  should  more  clearly  be  shown.  In  the  illustration 
already  used  it  is  desirable  that  the  ledger  should  contain 
the  two  accounts,  instead  of  having  the  depreciation  of  the 
machinery  credited  at  once  to  the  Machinery  Account.  But 
that  does  not  decide  the  form  in  which  the  Balance  Sheet 
is  to  appear  and  it  remains  debatable  which  of  the  two 
forms  given  below  is  preferable : 


Dr. 


FORM  24. 
Balance  Sheet. 


Cr. 


Machinery $10,000 

Other  assets 10,000 

$20,000 


Capital  stock $19,000 

Depreciation 1,000 

$20,000 


54 


MODERN   ACCOUNTING 


Dr. 


FORM  25. 
Balance  Sheet. 


Cr. 


Machinery 

Cost  price $10,000 

Less  depreciation     1,000    9,000 

Other  assets 10,000 

$19,000 


Capital  stock $19,000 


$19,000 


While  practice  is  by  no  means  uniform,  it  is  better, 
where  an  account  is  clearly  of  the  nature  of  a  Valuation 
Account,  to  allow  the  subtraction  to  appear  in  the  Balance 
Sheet,  somewhat  in  the  manner  just  indicated.  This  avoids 
any  danger  of  its  being  mistaken  for  some  other  class  of 
accounts,  which  might  lead  to  an  entire  misapprehension 
of  the  status  of  the  company.  Depreciation  and  Discount 
on  Capital  Stock  are  cited  here  as  typical  Valuation  Ac- 
counts ;  there  are  numerous  other  accounts,  however,  which 
come  under  the  same  category. 

The  purposes  of  .the  Balance  Sheet  are  twofold.  Pri- 
marily it  shows  the  financial  status  of  the  concern,  giving 
information  as  to  its  solvency,  and  in  a  less  degree  it  ex- 
hibits profits  which  have  been  made.  The  first  purpose  is 
on  the  face  the  most  evident  one.  The  Balance  Sheet  shows 
a  cross  section  of  the  business,  it  presents  the  status  at  a 
given  moment  of  time ;  it  is  ostensibly  a  showing  of  Assets 
and  Liabilities,  not  of  Income  and  Expenses.  Yet  the  Bal- 
ance Sheet  is  not  without  value  as  an  exhibit  of  profits. 
Prepared,  as  it  ordinarily  is,  at  annual  intervals  it  serves, 
at  least  by  comparison,  to  show  the  flow  of  income  during 
the  period,  as  well  as  the  financial  status  at  the  moment 
of  its  preparation.  Indeed  some  writers,  noticeably  Rehm, 
maintain  that  the  prime  function  of  the  Balance  Sheet  is 
to  show  the  profits  of  the  year  and  serve  as  a  basis  for  the 
declaration  of  dividends.  It  may  even  be  presented  in 


THE   BALANCE   SHEET  55 

such  form  as  not  only  to  show  the  profits  of  the  past  year, 
but  also  to  indicate  the  proposed  distribution  of  such 
profits.  This  may  be  done  perhaps  in  the  method  shown 
in  the  German  Balance  Sheet  on  page  65.  A  somewhat 
similar  treatment  is  found  in  the  Balance  Sheet  of  many 
English  companies — as  e.  g.,  that  of  J.  &  P.  Coats,  Lim. 

For  whichever  use  the  Balance  Sheet  is  designed  it  is 
evident  that  it  must  give,  as  far  as  possible,  a  correct  show- 
ing of  the  facts.  High  standards  have  been  set  in  this  re- 
spect by  the  statutes.  Thus  the  English  Companies  Act 
provides  that  the  Balance  Sheet  shall  be  "  drawn  up  so 
as  to  exhibit  a  true  and  correct  view  of  the  state  of  the 
company 's  affairs  ' ' ;  and  the  German  Commercial  Code 
prescribes  severe  penalties  for  ' '  untruthf ulness  or  unclear- 
ness  ' '  of  the  Balance  Sheet.  Nevertheless  accountants  gen- 
erally deny  the  possibility  of  strict  accuracy  in  the  Balance 
Sheet.  Thus  Dicksee  says:  "  A  Balance  Sheet  is  not  a 
statement  of  facts,  but  rather  an  expression  of  opinion," 
and  another  writer  has  said :  ' '  Not  more  than  ten  per 
cent  of  the  items  in  any  average  Balance  Sheet  are,  or 
can  possibly  be  facts  that  are  capable  of  being  absolutely 
tested." 

Unclearness  and  consequent  misunderstanding  of  Bal- 
ance Sheets  may  be  due  to  several  different  causes,  the 
principal  ones  being:  (1)  The  nature  of  accounting  itself, 
which  being  at  basis  an  estimate  can  never  be  absolute  or 
free  from  error.  (2)  The  vagueness  of  the  terminology 
used  and  the  liability  that  technical  words  will  be  misun- 
derstood, even  when  used  in  good  faith.  (3)  The  purpose- 
ful misrepresentation  of  the  condition  of  the  company  on 
the  part  of  the  directors  or  officers. 

1.  The  uncertainty  of  all  accounting  can  never  be  alto- 
gether avoided.  It  appears  principally  in  connection  with 
the  valuation  of  assets.  In  many  cases  there  is  no  outside 
criterion  of  value  and  no  way  of  insuring  against  a  wrong 


56  MODERN   ACCOUNTING 

estimate.    This  subject  is  discussed  in  the  chapters  dealing 
with  assets  and  their  valuation. 

2.  The  vagueness  of  terminology  adds  to  the  difficulty 
of  presenting  a  lucid  statement.     Technical  terms  such  as 
Reserve,  Reserve  Fund,  Treasury  Stock,  Adjustment  Ac- 
count, and  others  are  used  with  entirely  different  mean- 
ings by  different  companies  and  are  given  most  divergent 
definitions  by   the   courts  and  by  the  various  text-book 
writers.     Unfortunately  there  is  at  present  no  accepted 
authority  to  whom  appeal  can  be  made. 

The  likelihood  of  a  serious  misunderstanding  is  in- 
creased because  of  the  fact  that  items  so  widely  divergent 
in  character  stand  together  in  the  columns  of  the  Balance 
Sheet.  On  the  Debit  side  items  representing  losses  or  ex- 
penses may  be  confused  with  assets.  On  the  other  hand, 
the  Credit  column  contains  such  antipodal  items  as  Profits 
and  Depreciation — that  is,  those  showing  that  there  has 
been  an  increase  in  the  value  of  the  assets,  and  those  indi- 
cating that  the  value  of  some  of  the  assets  has  declined. 
Exactly  the  same  term  may  be  used  to  indicate  these  two 
categories,  for  both  are  frequently  covered  by  what  is 
called  Reserve.  Much  good  will  be  accomplished  by  the 
action  of  the  Interstate  Commerce  Commission  in  prescrib- 
ing certain  uniformities  in  railroad  accounting.  It  would 
be  well  for  the  public  accountants  of  the  country  to  take 
even  wider  action  in  securing  definite  and  uniform  account- 
ing terminology. 

3.  Purposeful  misrepresentation  in  the  Balance  Sheet 
is  secured  in  part  by  insidiously  taking  advantage  of  the 
inherent  difficulties  just  referred  to,  in  part  by  more  pal- 
pable untruth.    Of  the  latter  little  need  be  said.    Evidently 
if  a  company  deliberately  states  it  has  $100,000  cash  on 
hand  when  it  really  has  only  $10,000  no  knowledge  of  the 
principles  of  accounting  will  disclose  the  facts.    More  in- 
sidious are  the  less  open  misrepresentations.    Sometimes  a 


THE   BALANCE   SHEET  57 

purposeful  grouping  together  of  certain  items  will  conceal 
the  real  condition.  Thus  a  company  owning  $100  govern- 
ment bonds  and  $100,000  bonds  of  some  wildcat  company 
lists  them  under  the  heading  "  Government  and  other 
Bonds."  Or  it  lists  bonds  and  stocks  together  as  "  Bonds 
and  Other  Investments." 

More  flagrant  is  the  case  where  liabilities  have  been 
subtracted  from  the  assets,  as  for  instance  where  the  Bal- 
ance Sheet  does  not  show  both  Bills  Receivable  and  Bills 
Payable,  but  merely  the  excess  of  the  former  over  the  lat- 
ter; or  again  shows  only  the  equity  in  Real  Estate  instead 
of  both  the  cost  price  and  the  purchase-money  mortgage 
given  in  part  payment.  Even  the  improper  division  of  an 
account  may  be  resorted  to  in  order  to  hide  the  fact  that  a 
company  is  too  largely  involved  in  a  single  line  of  invest- 
ment. A  striking  example  of  this  came  up  in  connection 
with  the  disastrous  failure  of  the  Leipziger  Bank,  which 
divided  up  among  various  different  accounts  the  advances 
which  it  had  made  to  an  industrial  company,  hoping 
thereby  to  conceal  the  extent  to  which  the  bank  was  in- 
volved in  that  ruinous  enterprise. 

Against  the  positive  misstatements  in  the  Balance 
Sheets  the  outsider  is  of  course  defenseless.  But  assum- 
ing that  amounts  are  correctly  given  and  that  there  is  no 
gross  overstatement,  he  still  needs  to  be  on  guard  against 
a  misunderstanding.  He  should  be  sure  that  the  ambigu- 
ous titles  are  rightly  understood,  and  that  he  does  not  con- 
fuse accounts  of  opposite  nature.  A  most  important  aid 
in  this  matter  is  the  careful  indication  of  Valuation  Ac- 
counts in  the  manner  suggested.  Further  examination  of 
the  Balance  Sheet  and  of  the  other  statements  which  should 
accompany  it  is  then  possible.  The  difficult  points,  in  the- 
ory and  practice,  relate  to  substance  rather  than  to  form 
and  are  discussed  in  the  various  chapters  following. 

Reference  has  here  been  made  to  incorrectness  in  the 


58  MODERN  ACCOUNTING 

Balance  Sheet  as  being  an  admitted  fault,  or  even  a  fraud. 
Attention  should  be  called  to  the  fact  that  many  account- 
ants and  jurists  draw  a  marked  line  between  the  incor- 
rectness of  statement  which  places  the  company  in  a  more 
favorable  light  and  one  which  understates  its  financial 
strength  -or  minimizes  its  profits.  To  some  the  former  is 
fraudulent,  the  latter  almost  a  virtue.  It  suffices  here  to 
call  attention  to  this  point,  which  is  discussed  at  some 
length  in  connection  with  the  subject  of  Secret  Reserves. 
To  illustrate  the  variations  in  form  found  in  account- 
ing practice,  there  are  given  below  a  number  of  Balance 
Sheets  of  different  corporations.  Descriptive  notes  on  the 
forms  given  are  to  be  found  on  pages  67-68. 


THE  BALANCE  SHEET 


59 


o 


rH  OOS 
•<CH  rH  GO 
OS  t>TH 


CO  ^t*  rH  CO  O  CO 

Tt<      co      m  co  t>-  TJ< 

CO        TH  -*  CO  CO 


OOS 


OS  IO  rH 

O5  OiiC 

(N  TjH  OS 


CO  1C        CO  GO  C<> 

co  c^      ^  os  01 

CO  TH<N  t- 


..a   •  fe   •   •   :   

:  S  :  s  :  >»|  : 

• 

.... 

-S 

05             .J°      .-0      .    ®    ft     . 

1       |  '1   II 

S 

«3            * 

S 

0 

^         S     f 

•a'S 

V 

a 

ijjj 

1 

VESTMENTS: 
Road  and  equipment 
Sinking  funds  (less  Co 
sues  included)  .... 
Deposits  in  lieu  of  me 
t,v  sold  .  . 

Miscellaneous  physic 
Investments  in  affiliat 
Other  investments.  .  . 

I 
_g 

*3 
+= 
o 
H 

QRRENT  ASSETS  
EFERRED  ASSETS  .... 
N  ADJUSTED  DEBITS: 
Insurance  paid  in  ad'' 
Discount  on  funded  c 
Other  unadjusted  del 

1" 
§ 

K 

OQU 

FORM  27. 

THE  ATCHISON,  TOPEKA  &  SANlA 
GENERAL  BALANCE 


Balances 
June  30,  1901. 

ASSETS. 

Balances 
June  30,  1902. 

-412,361,783.19 

3,376,378.88 
3,803,278.10 
189,669.86 

$1,887,595.14 
460.611.34 
1,028,172.40 

RAILROADS,         FRANCHISES, 
AND  OTHER  PROPERTY,  in- 
cluding    Stocks,     Bonds, 
etc.  (Kxhibit  A)  

$2,723,775.51 
656,172.99 
7,226,772.68 

$418,982,696.40 

10,606,721.  li> 
10,321,617.75 

5,073,804.67 

EXPENDITURES     FOR     CON- 
STRUCTION    AND     EQUIP- 
MENT    DURING     CURRENT 
FISCAL  YEAR  (Exhibit  B) 
Improvements  

Extensions  

Equipment  

INVESTMENTS  IN  OTHER  Co.'s 
(Exhibit  C)  

$2,898,496.26 
577,126.51 

$2,895,896.26 
357,066.66 

NEW   YORK   SECURITY   AND 
TRTIST  Co.,  TRUSTEE  : 
Cash     and     Securities     in 
Special  Trust  

Balance  carried  down  

BALANCE  FROM  CAPITAL  AC- 
COUNT   

$419,731,110.03 

$444,984,840.00 

$4,495,870.03 

3,475,622.77 
2,293,276.35 
32,156.03 

242,958.00 
257,447.24 

5,542,035.68 
5,738.54 

9.484,200.69 

$3,252,962.92 
3,403,026.86 
32,019.98 

252,975.50 
548,032.72 

6,763,608.33 
1,276.06 

20,544,405.62 

SECURITIES   ON   HAND   (Ex- 
hibit D): 
Company's  Securities  (esti- 
mated value)  

Other  Securities  (estimated 
value)  

$1,387,659.94 
380,822.09 
503,125.97 
3,270,427.68 

MATERIAL  AND  SUPPLIES  

PREPAID     INSURANCE    PRE- 
MIUM   

$1,457,105.87 
372,429.30 
409,899.80 
4,524,173.36 

UNION  TRUST  Co.  OF  NEW 
YORK,  TRUSTEE: 
Cash  deposit  under  Article 
5  of  Gen'l  Mtge  

GUARANTY    TRUST    Co.    or 
NEW  YORK: 
Cash  deposit  for  Fuel  Re- 
serve Fund  

ACCOUNTS  RECEIVABLE: 
Traffic  Balances.           .  .  . 

Agents  and  Conductors.  .  .  . 
U.  S.  Government  

Miscellaneous  

PRIOR  ACCOUNTS  IN  LIQUID- 
ATION   

CASH: 
On  Hand  and  in  Bank  

$25,829,306.33 

$34,798,307.98 

fiO 


FE  RAILWAY  COMPANY— SYSTEM. 

SHEET,    JUXE   30,    I9O2. 


Balances 
June  30,  1901. 

LIABILITIES. 

Balances 
June  30,  1902. 

$102,000,000.00 

CAPITAL  STOCK: 
COMMON.-  

$102,000,000  00 

PREFERRED  

$131  486  000  00 

.    '    - 

Less  amount  in  Special 
Trust  : 
For  acqui- 
sition  of 
Auxilia- 
ry Lines.$10,800,000.00 
For  Im- 
prove- 
men  ts, 
Ex  ten- 
sions.etc.    6,486,470.00 

1  7  *>RR  d7f\  nn 

114  199  530  00 

$138,727,500.00 
51,728,000.00 

1,500,000.00 
250,000.00 

6,000,000.00 
830,210.00 

FUNDED  DEBT: 
General  Mtge  4%  Bonds.  .  . 
Adjustment  Mtge.  Bonds.  . 
Serial  Deben.  4%  Bonds.  .  . 
Chicago  &  St.  Louis  Ry. 
1st  Mtge.  6%  Bonds  
Equipment  Tr.  5%  Bonds. 
The  San  Francisco  <fe  San 
Joaquin  Valley  Ry.  Co. 
1st  Mtge.  5%  Bonds  
Miscellaneous  Bonds  

138,728,500.00 
51,728,000.00 
30,000,000.00 

1,500,000.00 

6,000,000.00 
828,810.00 

4,495,870.03 

Balance  carried  down  

$419731.110.03 

$444,984,840.00 

BALANCE  FROM  CAPITAL  AC- 
COUNT   

•#5  073  804  67 

$1,239,309.18 
559  747  39 

SPECIAL  BETTERMENT  FUND. 

ROLLING    STOCK    REPLACE- 
MENT FUND  

367,079.52 
211  687  57 

321  860  83 

RAIL  RENEWAL  FUND  

366  781  16 

59,412  56 

TIE  RENEWAL  FUND  

$239,386.58 

FUEL  RESERVE  FUND: 
The  Atchison    Topeka  <fe 
Santa  FeRy.  Co  

$489,834.90 

18,060.66 

Cherokee   <fc   Pittsburg   C. 
&  M.  Co  

58,197  82 

844,290.70 

$3,115,305.00 

ACCRUED  TAXES  NOT  YET  DUE 

INTEREST  ON  FUNDED  DEBT  : 
Accrued,  not  due  

$3,512,275.00 

953,103.64 

193,630.00 

Coupons,  not  presented..  .  . 

201,160.00 

SI  807,310.16 

ACCOUNTS  PAYABLE: 
Pay  Rolls  

$1  ,954,254.70 

2.428,257.98 

Audited  Vouchers  

3,637,781111 

1,488,466.9Q 

Traffic  Balances  

1,452,391.22 

139,911.83 

Miscellaneous  

272,162.34 

5  863  946  96 

7  01  ft  coo  07 

268,616.06 

PRIOR  ACCOUNTS  IN  LIQUIDA- 
TION   

220  379  1  1 

13,082,740.41 

PROFIT  AND  Loss  :  Surplus.  .  . 

16,027,415.23 

$25,829,306.33 

$34,798,307.99 

81 


62 


1 

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.18 


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-73000 

co  O  O 


1O        O        CO        O5        O5 
(N        CO        00        CO        O 


to  oo  *o 

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T}<  i— I  i— I 

1C  <O~  00" 

t>»  1— I  f- 

•^  00  00 


•^    03    £  O  Hi  r~    X  •«  2  /is  •**  +a      I  Jaw 

rt  ^go"-0*-5  Cjj^Q  c£  d  — 
oSO^^-a,.]     pq-gw^^  §j  gw  t» 


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to  t^ 

0000 


OO 


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2    8 


£ 


Fc 


CONDENSED  GENERAL 


ASSETS 
PROPERTY  ACCOUNT 

Ptoramis  OWNED  AND  OPB«TB>  BY  THE  SEVEXAL  COMPANIES 

Balance  of  this  account  as  of  December  31.  1906   $1,378.185,605  07 

Additions   during   1907   to   foregoing   balance  (see  page  26) . 614^22.63 

Tennessee  Coal,  Iron  &  R.  R   Co's  Properties,  viz. 

Cost  of  Fixed  Property  as  acquired  at  November  I,  1007.  $48,961. 308,83 

Expended  for  Construction  in  November  and  December 984,886.74 

—————          40  046,005  57 
Expended  for  Additional  Property  and  Construction  in  1907  other  than  by  or 

for  account  T.  C,' I.  4  R.  R.  Co 65,996^65.73 

Las,  Charged  off  to  the  following  accounts,  viz.: 

To  Bond  Sinking  Funds. . .' $572,500.00 

To  Depreciation,  Extinguishment  and  Replacement  Funds      4680,421 .03 
To  Funds  provided  from  Surplus  Net   Income  for  pay- 
ment of  capital  expenditures  (see  page  12) 53,949.799. «6 

59.202,730.40, 

Expenditures  for  Stripping  and  Development  at  Mines,  and  in- 
vestment in  Structural  Erection  and  Logging  Plants,  viz. : 

Balance  at  December  31,  1906 . $5^22340.61 

Net  Increase  during  the  year  1907 .-.-...      4.575,041 .26 

10,207.381 .87 

DEFERRED  CHARGES  TO  OPERATIONS  »1.44S.S37,«O.37 
Payments  for  Advanced  Mining  Royalties,  "Exploration  expenses  and  Miscel- 
laneous charges,  chargeable  to  future  operations  of  the  properties : . .          $6,204,733.85 

Less:  Fund  reserved  from  Surplus  to  cover  possible  failure  to  real- 
ize Advanced  Mining  Royalties 2.300.000.00 

INVESTMENTS  3.7O4.733.WJ 

Outside  Real  Estate  and  Other  Property 1,717,110.87 

SINKING  AND  RESERVE  FUND  ASSETS 

Cash  resources  held  by  Trustees  account  of  Bond  Sinking  Funds $444,200.88 

($3'.559.ooo  par  value  of  Redeemed   Bonds  held  by  Trustees,  not 

Contingent  Fund  and  Miscellaneous  Assets , 1,215322.85 

Insurance  Fund  Assets  (at  market  value).: 4,120.158.63 

Depreciation  and  Extinguishment  Fund  Assets  (at  market  value) 10741,977.19 

Investments  (at  market  value)  for  Special  Construction  Fund  for  Gary  Plant..  15,920.542.14 
CURRENT  ASSETS                                                                                                                                      32,448,401. <M> 

Inventories* $136,188374-26 

Accounts  Receivable 58,398^54.36 

Bills  Receivable,  Customers'  and  Guaranteed  Loans : 10,193,706.91 

Agents'   Balances , 835,369.33 

Sundry  Marketable  Bonds  and  Stocks _ , :  8,831.154.33 

Loans  on  Collateral 6,000,000.00 

Cash,  viz.: 

In  hand  and  on  deposit  with  Banks,  Bankers    and    Trust 

Companies  subject  to  cheque $51,222,305.07 

Deposits  loaned  on  call 2.741.453.81 

53.9f4.848.88 

274,41 1 .308.08 


Mory    valuation*    include     profit*     accrued 


aid    to    other 


•r    bd 


w< 


•  Balance  Sheet,  and  certify  that  in 


audited  the  abov 
Our  opinion  it  is  properly  dr; 
cial  position  of  the  United  States  Steel  Corporation  and  Subsidi- 
ary Companies  on  December  31,  1907 

PRICE,  WATERHOUSE  ft  CO., 

Auditors. 
NEW  You*.  March  7.  1908. 


*l,75*t,l  13,013. «<l 


29. 
SHEET,  DECEMBER  31.  1907. 


LIABILITIES 

CAPITAL  STOCK  OF  U.  S.  STEEL  CORPORATION 

Common , . . ., $508,302, 500 . oo 

Preferred   , ,.. 360,281,100.03 

8868,583,600.00 

CAPITAL  STOCKS  OF  SUBSIDIARY  COMPANIES  NOT  HELD  BY  U.  S. 

STEEL  CORPORATION  (Par  Va\*t) 761.81O.OO 

BONDED  AND  DEBENTURE  DEBT 

United  States  Steel  Corporation  50  Year  %%  Bonds $303,057,000.00 

United  States  Steel  Corporation  10-60  Year  s%  Bonds 200.000,000.00 

$503,957,000.00 
Less,  Redeemed  and  held  by  Trustees  of  Sinking  Funds. .      23.758.000-00 

Balance  outstanding $480,190,000  CO 

Subsidiary  Cos.'  Bds.  (Guaranteed  by  U   S.  Steel  Corp'n).  ...     $48,036.000  oo 
Subsidiary  Cos.'  Bds.  (Not  guaranteed  by  U  S.  Steel  Corp'n).       79,716,004.13 

$127,752,904 .13 
Less,  Redeemed  and  held  by  Trustees  of  Sinking  Tunds. .        7,801,003.00 

Balance  outstanding , 110,951,904  13 

Debenture  Scrip,  Illinois  Steel  Company 34.366.66 

CAPITAL  OBLIGATIONS  AUTHORIZED  OR    CREATED    FOR    CAPITAL  600,186.270.79 

EXPENDITURES  MADE  (HELD  IN  THE  IBEASUBY  SUBJECT  TO  SALE,  HUT 

HOT  INCLUDED  IN   ASSETS— See  page   l'5). 

Subsidiary  Companies'  Bonds,  not  included  in  this  Balance  Sheet  as  either  a 

Liability  or   an   Asset $10,222.00000  _        _        _ 

MORTGAGES  AND  PURCHASE  MONEY  OBLIGATIONS  OF  SUBSIDIARY 
COMPANIES 

Mortgages   '. $2.135440.38 

Purchase  Money  Obligations 3.258.700.65 

CURRENT  LIABILITIES 

Current  Accounts  Payable  and  Pay  Rolls $22,506,488.45 

Bills  Payable  (of  Tenn.  Coal,  Iron  &  R   R.  Co.) 1,052.747.59 

Special  Deposits  or  Loans  due  employes  and  others 1.057,495  -  58 

Accrued  Taxes  not  yet  due. 3.7J6.747  8» 

Accrued  Interest  and  Unpresented  Coupons 7,863.913.57 

Preferred  Stock  Dividend  No.  27,  Payable  February  29,  1068 6^04^19.25 

Common  Stock  Dividend  No.  17.  Payable  March  30.  1908....  2,541.512.50              4606382474 

Total  Capital  and  Current  Liabilities : Cl,619,tttt8,446.36 

SINKING  AND  RESERVE  FUNDS 

Sinking.  Depreciation  and  Replacement  Funds,  per  table  on  page  lo $41,360,655.10. 

General  Construction  Fund  for  authorized  appropriations  (see  page  12) 3&3&8I4-96 

Special  Construction  Fund  for  account  Gary,  Ind,  Plant  (see  page  12) 26,051,242.62 

Contingent  and  Miscellaneous  Operating  Funds 7,991.275  89 

Insurance  Funds  4.648.358  57 

—  83,975,347 .23 

BOND  SINKING  FUNDS  WITH  ACCRETIONS  . 31,SO3,97e.4B 

Represented  by  Cash  (and  by  redeemed  bonds  not  treated  as  assets — See  Contra). 

UNDIVIDED  SURPLUS  OF  U.  S.  STEEL  CORPORATION  AND  SUB- 
SIDIARY COMPANIES 

Capital  Surplus  provided  in  organization $25,000.000.00 

Balance  of  Surplus  accumulated  by  all  companies  from  April  1, 1901,  to  Decem- 
ber 31,  1907,  per  table  on  page  34 69,736,490  77 

Total   Surplus  exclusive  of  Subsidiary  Companies'  Inter-Company 

Profits  in  Inventories $94J36^oo.77 

Undivided  Surplus  of  Subsidiary  Companies,  representing  Profits  accrued  on 
sale  of  materials  and  products  to  other  subsidiary  companies  and  on  hand 

in  tatter's.  Inventories 27  008  /*,->  8, 

122,646.843.68 

«1,7C8,1 13,018.86 


THE   BALANCE   SHEET 


63 


Bank. 


f  a  Nat 


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So 
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O^      •      •      "SH-i^c^"4~sC  ^         **"*    ^    £•<  ^  ^  ^Ss  /^ 


MODERN   ACCOUNTING 


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O  CO  CO  CO 

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O  O  •— <  i— I 


2 


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«  O   yjS   §D~   <0" 
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ICQ* 


THE   BALANCE   SHEET 


FORM  32. 
Balance  Sheet  of  a  German  Manufacturing  Corporation. 
Active.  Passive. 

CO  CO  00        CO                    00 
(M  OOCi        I-H                    <N 

1,395,542.48 

8i>  r-  rfi  o  oo              •*  - 
•^  CO  Oi  C^  *O                   f"~ 

o  I*-  co  CNJ      10              o 

C5  i-H         i—  1                                    "—I 

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1~l     °°        ^oo^iS 

i  :  '.  ;  '•  :     •  °  ^  1  _«  '  •  2  -^ 

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-1  eg+2..23      ^^  :°l 
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1|||||1|||||||| 

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THE  BALANCE  SHEET  67 


NOTES  ON  THE  FORMS  OF  BALANCE  SHEETS 

FORM  26. — This  form  divides  the  Assets  into  four,  the 
Liabilities  into  seven  groups.  Some  of  the  items  listed  under 
Unadjusted  Debits  are  similar  to  those  generally  called 
Deferred  Assets.  The  title,  Deferred  Liabilities  as  here 
used,  is  somewhat  meaningless.  The  separate  item,  Govern- 
mental Grants,  is  a  distinct  innovation.  It  represents  a 
contribution  which  does  not  come  from  the  stockholders,  yet 
is  not  a  debt.  The  treatment  of  Corporate  Surplus  and  of 
Depreciation  is  particularly  to  be  noted. 

FORM  27. — This  Balance  Sheet  is  in  the  Double  Account 
form,  although  the  two  portions  are  not  separately  headed 
as  is  customary  in  the  statements  of  Parliamentary  com- 
panies. Attention  is  also  called  to  introduction  of  the  fig- 
ures of  the  preceding  year's  Balance  Sheet  for  the  sake  of 
comparison. 

FORM  28.— This  Balance  Sheet  of  the  London  and  West- 
minster Bank  not  only  arranges  the  assets  with  the  most 
liquid  form  coming  first,  but  logically  observes  a  similar 
arrangement  of  the  liabilities.  Other  features  of  interest 
are :  The  treatment  of  unpaid  capital,  tha  showing  of  liabil- 
ities for  endorsement,  etc.,  and  the  divergent  methods  used 
in  showing  Depreciation  of  Government  Securities  and  the 
amount  written  off  of  Bank  Premises. 

FORM  29.— This  Balance  Sheet  has  many  points  of  in- 
terest among  which  are :  The  consolidation  in  one  state- 
ment of  the  assets  and  liabilities  of  the  subsidiary  compa- 
nies as  well  as  those  of  the  Steel  Corporation,  the  treatment 
of  Depreciation,  the  differentiation  of  the  various  Reserves 
and  of  their  corresponding  assets,  and  the  treatment  of 
the  Bond  Sinking  Fund. 

FORMS  30-31.— These  two  Balance  Sheets  represent  the 
condition  of  the  Chemical  National  Bank  of  New  York. 


68  MODERN   ACCOUNTING 

The  first  is  in  the  form  furnished  the  Comptroller  of  the 
Currency  and  by  him  published  in  the  annual  report.  The 
second,  is  a  condensed  form  used  as  an  advertisement  ap- 
pearing in  the  Commercial  and  Financial  Chronicle.  The 
difference  in  the  figures  is  due  to  leaving  the  overdrafts 
out  of  the  condensed  form  and  showing  only  the  net  sum 
due  depositors.  Strictly  this  is  incorrect.  It  involves  the 
cancelation  of  assets  against  liabilities,  which  is  opposed 
to  the  general  principle  that  both  must  be  shown  in  full. 
The  small  amount  involved  however  furnishes  sufficient 
justification  for  the  omission. 

FORM  32.— This  form  (taken  from  Rehm's,  "  Die  Bilan- 
zen  ")  is  a  typical  German  Balance  Sheet.  Points  of  spe- 
cial interest  are:  The  arrangement  of  assets  from  fixed  to 
liquid,  the  inclusion  of  unrealizable  assets  at  a  nominal 
value  of  1  mark  (such  items  being  technically  called 
"  memoriter  accounts  "),  and  the  inclusion  of  many  of 
the  details  of  the  Profit  and  Loss  Account  in  the  Balance 
Sheet.  Item  17  "  Delkredere  Account  "  is  a  term  seldom 
used  in  English  accounting  literature  although  occasion- 
ally found.  It  signifies  about  the  same  as  "  Reserve  for 
Doubtful  Debts  "  or  for  some  similar  uncertain  asset. 

FORM  33.— This  form  has  doubtless  had  a  great  effect 
on  English  practice  as  its  use  was  for  many  years  obliga- 
tory for  all  companies  which  did  not  specifically  adopt 
other  articles.  The  British  custom  of  placing  the  assets  on 
the  left  hand  side  has  been  due  largely  to  this  legal  form. 
Under  the  modification  of  Table  A  made  in  1906  the  use 
of  this  particular  form  is,  however,  no  longer  prescribed. 
Other  points ,  of  interest  are :  The  minute  details  regard- 
ing the  issue  and  payment  of  shares,  the  addition  of  con- 
tingent liabilities  as  a  supplement  to  the  Balance  Sheet 
proper,  the  classification  of  items  in  seven  heads,  and  the 
arrangement  of  assets  with  cash  last. 


THE   BALANCE    SHEET  69 


BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  III 

BROAKER  &  CHAPMAN.  The  American  Accountants'  Manual.  I, 
pp.  83-108.  New  York,  1897. 

CHARPENTIER,  J.  Etude  juridique  sur  le  bilan  dans  les  societes 
par  actions.  Paris,  1906.  [A  good  presentation  of  French 
law  and  custom,  containing  also  a  bibliography.] 

A  CHARTERED  ACCOUNTANT.  How  to  Understand  the  Balance 
Sheet.  London,  1903. 

GOUGH,  T.  H.  Balance  Sheets  and  How  to  Read  Them.  London, 
1906. 

KEEN,  F.  N.  The  Balance  Sheet  of  a  Limited  Company.  Ac- 
countant, XXIV,  p.  399. 

LISLE,  G.  Balance  Sheets.  Article  in  Encyclopaedia  of  Account- 
ing. I,  p.  203. 

Accounting  in  Theory  and  Practice,  pp.  69-82.  Edin- 
burgh, 1903. 

PIXLEY,  F.  W.  How  to  Read  a  Balance  Sheet.  Accountant, 
XXXV,  p.  511.  [A  valuable  article  by  the  former  president 
of  the  Institute  of  Chartered  Accountants.] 

REHM,  H.  Die  Bilanzen  der  Aktiengesellschaften.  Munich,  1903. 
[The  most  comprehensive  work  on  the  subject,  dealing  how- 
ever with  the  details  of  German  law.] 

SIMON,  H.  V.  Die  Bilanzen  der  Aktiengesellschaften.  3te  Aufl. 
Berlin,  1899.  [A  work  similar  to  Rehm's.  Although  less 
comprehensive  it  is  perhaps  more  valuable  to  the  general 
student  of  accounting.  While  dealing  with  German  law  the 
discussion  of  theoretical  matters  is  of  general  interest.] 

VIGEON,  H.     Balance  Sheets.     Accountant,  XXV,  p.  29. 

An  interesting  collection  of  various  forms  of  Balance  Sheets  with 

critical  comments  is  found  in  Encyclopaedia  of  Accounting,  VIII, 

pp.  249-326. 


CHAPTER   IV 

ASSETS   AND   THE   PRINCIPLES   OF   THEM   VALUATION 

IN  the  preceding  chapter  it  was  shown  that  where  the 
ledger  is  properly  closed  so  as  to  eliminate  expense  and 
other  loss  items,  the  left  side  of  the  Balance  Sheet  con- 
tains only  two  classes  of  items:  (1)  those  indicating 
assets,  and  (2)  those  indicating  Valuation  Accounts— that 
is,  technical  accounts  whose  object  is  to  indicate  a  subtrac- 
tion to  be  made  from  items  listed  on  the  other  side  of  the 
Balance  Sheet.  But  this  latter  class  of  accounts  is  always 
small  in  number,  and  in  the  more  approved  Balance  Sheet 
the  Valuation  Accounts,  too,  are  eliminated  from  the  left 
side  by  being  listed  in  an  interior  column  of  the  right 
side,  the  exterior  column  showing  the  remainder  after  de- 
ducting the  indicated  amount.  The  left  column  of  the 
Balance  Sheet  containing,  then,  in  most  cases,  nothing  but 
asset  items,  and  in  any  event  having  few  accounts  other 
than  these,  that  column  has  generally  been  called  by  its 
characteristic  feature,  and  is  labeled  "  Assets  "  or  "  Re- 
sources. ' ' 

But  while  negative  items,  whether  representing  actual 
losses,  or  mere  technical  Valuation  Accounts,  appear  infre- 
quently in  a  properly  prepared  Balance  Sheet,  the  impor- 
tance of  distinguishing  all  such  items  from  asset  items 
proper  cannot  be  overemphasized.  A  failure  to  do  so 
causes  most  of  the  misrepresentations  or  misunderstand- 
ings of  corporation  accounts.  Thus,  with  a  given  sum,  say 
$50,000  worth  of  unquestioned  assets,  there  may  appear  in 
the  Balance  Sheet  another  item  of  $10,000  of  indeterminate 

70 


ASSETS   AND   THEIR   VALUATION  71 

character.  If  it  proves  to  represent  Goods  the  concern 
then  is  possessed  of  $60,000  gross  assets  with  which  to 
secure  its  creditors  and  indemnify  its  stockholders.  But 
if  the  $10,000  item  is  merely  a  Valuation  Account,  or  one 
representing  a  loss,  it  is  a  serious  error  to  add  it  to  the 
real  assets,  for  the  false  estimate  of  this  additional  prop- 
erty may  mislead  the  creditor  or  investor.  Frequently 
Loss  items  are  thus  carried  in  the  Balance  Sheet  with  some 
colorless  or  misleading  title,  and  a  gross  misconception  of 
the  actual  status  of  the  concern  is  the  result.  Thus  a  man- 
ufacturing concern  engaged  in  making  harvesters,  carried 
in  its  Balance  Sheet  the  following  items:  Moving  account, 
Fair  machines  account,  Material  and  labor  expended  on 
self-binder,  Bindery  account.  In  each  of  these  instances 
the  court  decided  that  the  item  represented  an  expense 
and  not  an  asset,  and  the  confusion  in  this  case  amounted 
to  a  positive  fraud  on  the  creditors  of  the  company.  To 
one  interpreting  a  Balance  Sheet,  or  to  one  charged  with 
the  duty  of  preparing  it,  the  first  duty  is  to  distinguish 
properly  between  assets  and  the  negative  items  which  ap- 
pear in  the  ledger,  and  which  if  not  correctly  treated  will 
appear  on  the  debit  side  of  the  Balance  Sheet,  in  the  goodly 
company  of  the  assets.  The  better  rule  is  to  eliminate 
such  altogether  from  the  asset  side  of  the  Balance  Sheet, 
but  where  for  some  reason  this  is  not  done,  it  is  indis- 
pensable that  they  be  so  labeled  and  distinguished  that 
there  may  be  no  uncertainty  as  to  their  real  nature. 

The  difficulty  in  making  proper  discrimination  is 
greater  because  the  ledger  itself,  of  which  the  Balance 
Sheet  is  an  abstract  and  epitome,  does  not  immediately 
serve  as  a  guide.  The  original  transaction  was  a  payment 
of  cash  for  services  rendered  or  material  supplied.  Cash 
being  diminished,  the  cash  account  was  properly  credited 
and  some  other  special  account,  "  Bindery  account  "  in 
the  instance  cited,  was  debited.  But  exactly  the  same 


72  MODERN  ACCOUNTING 

booking  might  legitimately  be  made  whether  the  payment 
was  a  loss  transaction,  or  an  exchange ;  whether  the  amount 
standing  to  the  debit  of  "  Bindery  "  represents  an  expense 
or  an  asset.  Nor  can  the  proper  determination  be  based 
on  the  crude  fact  of  whether  or  not  there  was  an  actual 
purchase  of  material.  For  convenience  in  accounting  it  is 
customary  to  treat  some  purchases,  such  as  stationery,  fuel, 
oil,  or  material  or  equipment  needed  for  replacements  as 
an  immediate  expense ;  and  on  the  other  hand  certain  pay- 
ments such  as  wages,  and  interest,  for  which  nothing  tangi- 
ble is  received  in  exchange,  are  at  times  legitimately 
treated  as  representing  the  cost  price  of  some  tangible  or 
intangible  asset.  "Whether  a  given  payment  is  an  expense 
(Loss  or  "  Negative  Proprietorship  "  transaction)  or 
whether  it  is  the  means  of  securing  an  equivalent  asset 
(Exchange  transaction)  is  a  fundamental  problem,  but  one 
sometimes  difficult  of  determination.  In  either  case  it  first 
appears  upon  the  books  as  a  Debit  entry  in  some  account, 
and  may,  therefore,  ultimately  be  found  among  the  items 
which  appear  on  the  Debit  side  of  the  Balance  Sheet. 
Confusion  may  result  either  from  purposeful  deception, 
or  from  the  misunderstanding  of  ambiguous  or  doubtful 
titles. 

The  difficulty  of  distinguishing  between  these  two 
classes  of  transactions  has  been  made  prominent  in  railway 
accounting.  To  use  the  technical  terms,  it  is  an  ever-recur- 
ring problem  whether  a  given  expenditure  is  a  Revenue 
Expenditure  or  a  Capital  Expenditure,  whether  it  goes 
into  Operating  Expenses  or  into  Construction  Account.  If 
regarded  as  a  Revenue  Expenditure  it  works  as  a  charge 
against  earnings  and  so  reduces  the  net  profits.  If  a  Cap- 
ital Expenditure,  the  Construction  Account,  that  is,  the 
account  representing  the  cost  of  the  road,  is  debited  and 
the  equivalent  of  the  money  expended  is  therefore  carried 
among  the  assets  in  the  Balance  Sheet. 


ASSETS   AND   THEIR   VALUATION  73 

No  less  than  three  theories  exist  as  to  the  proper  divi- 
sion of  expenditures  between  capital  expenditures  and 
charges  against  revenue. 

(1)  The  most  commonly  accepted  is  that  in  so  far  as 
the  transaction  results  in  an  addition  of  substantial  and 
permanent  character  which  increases  the  value  of  the  plant 
such  increase  should  be  made  to  the  construction  account. 
(Mackintosh  v.  Flint  &  Pere  Marquette  Ry.  34.  Fed.  Rep. 
609).    Or  as  it  is  clearly  expressed  in  Hubbard  v.  Weare: 
'*  Money  paid  out  should  not  be  reckoned  as  an  asset.    If 
paid  for  property  that  is  on  hand,  the  property  is  an 
asset.    If  expended  in  a  way  that  has  enhanced  the  value 
of  the  general  assets  it  is  included  in  its  valuation.     If  so 
expended  as  to  have  brought  no  property,  and  no  enhance- 
ment of  that  on  hand  then  it  is  a  loss,  and  should  not  be 
counted  as  an  asset."     (79  la.  678.) 

(2)  A  more  extreme  view  is  that  expressed,  for  in- 
stance, by  T.  F.  Woodlock :  ' '  An  addition  which  does  not 
increase  revenue  or  diminish  expenditure  is  not  a  proper 
capital  charge  according  to  the  best  modern  practice  in 
railroads.     That  which  simply  tends  to  hold  business  and 
not  to  increase  business  is  a  proper  charge  against  operat- 
ing expenses. ' ' l 

(3)  At  the  other  extreme  is  the  view,  presented  in  the 
decision  by  Lord  Kyllachy  in  Cox  v.  Edinburgh  and  Dis- 
trict Tramways  Company,  Lim.   (6  S.  L.  T.  63,   [1898]) 
that  where  an  improvement  is  made  in  the  plant,  even 
though  it  be  in  the  nature  of  the  substitution  of  new  plant 
for  old,  the  entire  cost  of  the  new  plant,  and  not  merely 
the  excess  in  value  of  the  new  over  the  old  may  be  charged 
to  Construction  account. 

Of  these  three  views  the  first  is  not  only  the  most  gen- 
erally accepted  but  seems  to  comport  best  with  account- 
ing principles.  It  has  furthermore  been  authoritatively 

1  Engineering  Magazine,  xi,  241. 


74  MODEKN   ACCOUNTING 

adopted  for  railway  accounting  by  the  Interstate  Com- 
merce Commission.  The  second  view,  while  praised  for  its 
conservatism  seems  to  imply  that  there  nmst  be  a  constant 
rate  of  normal  interest  or  profits,  a  condition  denied  by 
economic  history.  If  a  general  decline  in  profits  occurs  an 
improvement  which,  in  a  given  enterprise,  prevents  the 
fall  and  maintains  the  old  rate  of  profits  is  clearly  a  source 
of  additional  value,  and  would  be  capitalized  in  the  money 
market.  The  third  view  is  rarely  justified  by  accountants, 
but  the  principle  involved  is  not  dissimilar  to  that  con- 
cerned in  the  question  of  the  loss  of  capital  discusr^d  fully 
in  Chapter  XII. 

Assuming  (a)  that  it  has  been  possible  to  differentiate 
all  expense  items  and  (&)  that  all  expense  accounts  have 
been  closed  into  Profit  and  Loss,  and  further  (c)  that  all 
mere  Valuation  Accounts  are  deducted  from  the  appro- 
priate account,  the  Balance  Sheet,  in  its  best  form,  con- 
tains on  the  Debit  side  a  list  of  all  the  assets  belonging  to 
the  concern  and  nothing  else.  In  other  words  it  is  a  com- 
plete inventory,  and  in  its  preparation  enter  all  the  prob- 
lems connected  with  taking  an  inventory  of  goods  on 
hand. 

The  problems  of  the  inventory  are  three:  (1)  What 
items  are  to  be  included  in  it?  (2)  What  expenditures 
are  to  be  considered  as  entering  into  their  cost  price?  (3) 
In  subsequent  revaluations  are  the  assets  to  be  continued 
at  the  original  valuation  or  are  their  values  to  be  estimated 
on  some  new  basis  ? 

These  three  problems  are  not  entirely  distinct.  They 
may  all  be  implied  in  the  last  one,  that  of  the  current  re- 
valuation of  assets;  for  it  evidently  matters  not  whether 
an  object,  say  a  worn-out  machine,  be  excluded  from  the 
list  of  assets  or  be  valued  at  zero ;  it  matters  not  what  was 
the  original  value  of  an  asset  if  at  each  new  inventory  it 
must  be  independently  revalued.  But  in  practical  ac- 


ASSETS   AND   THEIE   VALUATION  75 

counting  the  questions  are  likely  to  arise  somewhat  in  the 
form  and  order  given  above. 

1.  What  items  are  to  be  included  in  the  inventory? 
The  underlying  principle   is   that   all  valuable   goods 

are  to  be  included.  Goods  is  here  used  in  the  proper  most 
inclusive  sense  of  all  desirable  things  and  does  not  in  any 
sense  imply  a  discrediting  of  immaterial  or  intangible 
property.  Whether  the  property  be  material,  consisting  of 
land,  or  permanent  plant,  or  of  merchandise;  whether  it 
be  less  tangible  credits  such  as  securities,  customers'  notes, 
or  merely  non-negotiable  book-accounts;  or  whether  it  be 
that  most  elusive  form  of  property,  Goodwill;— in  any 
event,  all  goods  are  alike  to  be  included  in  the  inventory. 
While  Goodwill  and  the  allied  immaterial  goods  such 
as  patent  rights,  and  trade  names  are  forms  of  property 
to  which  legal  rights  adhere,  it  may  even  be  correct  to  in- 
clude among  assets  items  representing  the  cost  of  some 
good  to  one  who  has  no  real  property  right  therein.  For 
instance,  the  money  paid  by  a  railroad  company  to  im- 
prove a  street  giving  access  to  its  station,  or  the  contribu- 
tion which  it  has  made  to  the  cost  of  a  tunnel  are  cited  as 
items  which  may  legitimately  be  reckoned  among  the  assets 
of  a  company  although  it  has  acquired  no  legal  property. 

2.  What  is  the  cost  price  ? 

At  the  time  of  acquiring  a  new  asset  it  is  normally 
listed  at  its  cost,  even  though  the  purchaser  thinks  he 
has  bought  it  at  a  great  bargain.  But  oftentimes  it  is 
not  easy  to  determine  just  which  expenditures  entered  into 
the  cost  of  the  particular  asset.  This  may  well  be  illus- 
trated by  the  case  of  a  railroad  where  its  principal  asset 
is  the  roadway,  which  in  accounting  frequently  appears 
under  the  title  Construction  Account.  The  cost  of  right  of 
way,  the  purchase  price  of  rails  and  ties,  the  labor  of 
engineers,  superintendents  and  laborers  are  all  clearly  part 
of  the  cost  of  acquiring  the  road,  and  are  to  be  charged  to 


76  MODERN   ACCOUNTING 

the  Construction  Account.  But  a  more  debatable  question 
arises  concerning  payments  not  made  in  the  form  of  a 
direct  purchase  of  property  or  payment  for  productive 
labor  but  which  may  perhaps  be  construed  as  the  cost 
price  of  acquiring  the  property.  In  this  class  come  what 
are  known  as  Organization  Expenses.  For  instance,  a  cor- 
poration is  started  with  $100,000  capital,  all  of  which  is 
paid  in  cash.  In  the  process  of  organizing  the  corporation, 
expenses  must  be  incurred  for  stationery  and  printing,  for 
engraving  certificates  of  stock,  for  fees  paid  to  the  state, 
and  to  attorneys.  These  may  amount,  say,  to  $2,500.  Is 
this  sum  merely  an  expense,  or  does  it  represent  part  of 
the  cost  ?  If  an  expense,  the  corporation  is  in  the  position 
of  having  encroached  on  its  capital,  for  with  a  capital  stock 
of  $100,000  it  has  no  assets  whatever  except  cash,  and  of 
that  it  has  only  $97,500. 

Interest  charges  are  normally  an  unquestioned  expense, 
but  even  interest  may  at  times  be  construed  as  capital  ex- 
penditure. Thus  a  railroad  borrows  money  with  which  to 
construct  the  road,  an  undertaking  which  will  require  sev- 
eral years.  During  the  period  of  construction  interest 
must  be  paid  while  no  revenue  is  accruing.  It  is  not  un- 
reasonable to  say  that  the  asset  which  the  company  is 
acquiring  is  a  finished  road  ready  for  operation.  To  secure 
such  a  plant  there  must  be  paid  not  merely  the  cost  of 
material  and  equipment,  the  salary  of  engineers  and  the 
wages  of  laborers,  but  equally  essential  is  the  payment 
of  interest  to  the  bondholder.  Without  this  latter  pay 
ment  the  finished  road  could  not  be  acquired.  To  include 
it  among  the  costs  of  construction  is,  therefore,  not  illog- 
ical, and  the  custom  of  so  doing  is  gaining  increasing  legal 
sanction.  In  an  early  American  case  (Gratz  v.  Redd.  4.  B. 
Mon.  (Ky.)  178)  the  court  held  that  interest  on  bonds  is 
not  to  be  charged  to  construction,  but  the  present  practice 
permits  the  interest  paid  during  the  period  of  construction 


ASSETS   AND   THEIR   VALUATION"  77 

to  be  added  to  the  cost  of  the  road.  In  England  the  similar 
early  opposition  on  the  part  of  the  courts  has  been  re- 
moved by  the  Companies  Act  of  1907  which  virtually 
makes,  not  merely  interest  on  bonds,  but  even  dividends  on 
capital  paid  in  lieu  of  interest  during  construction,  a  part 
of  the  construction  costs.  And  in  Germany,  where  the 
statutory  regulation  of  accounting  practice  is  generally 
much  more  specific  than  in  either  England  or  America, 
both  interest  and  dividends  thus  paid  are  chargeable  to 
11  Construction  Account."  Some  have  argued  that  the 
discount  on  bonds  sold  should  also  be  charged  to  the  cost 
of  the  road.  But  so  far  as  the  bonds  run  longer  than  the 
period  of  construction,  the  justification  of  such  a  practice 
rests  on  an  illogical  distinction  between  discount  paid  in 
advance,  and  current  interest  installments.  As  is  shown 
in  the  Chapter  on  Liabilities,  discount  on  bonds  is  prepaid 
interest  for  the  entire  life  of  the  loan,  and  it  is  only  inter- 
est during  construction,  not  for  the  later  period  that  can 
legitimately  be  construed  as  part  of  the  cost  of  construc- 
tion. The  Interstate  Commerce  Commission  has  ruled  that 
discount  on  securities  is  not  properly  included  in  the  cost 
of  property. 

A  similar  problem  arises  in  connection  with  the  ex- 
penses incurred  in  making  experiments  in  search  of  new 
inventions,  now  a  recognized  part  of  many  industrial 
plants.  This  may  be  treated  as  a  part  of  general  expense 
but  there  is  colorable  argument  on  the  other  side.  An  im- 
provement might  be  secured  by  purchasing  a  patent  right 
from  an  outside  inventor.  The  alternative  plan  is  to  hire 
the  inventor  to  work  for  the  company,  in  which  case  the 
salary  and  other  expenses  incurred  seem  to  be  the  cost  of 
the  secured  invention  just  as  truly  as  the  price  paid  for 
the  patent  right.  If  this  is  so,  may  not  expenses  be 
counted  as  part  of  the  prospective  cost  even  though  the 
goal  has  not  been  quite  reached? 


78  MODERN  ACCOUNTING 

From  the  foregoing  it  is  seen  that  it  is  by  no  means 
easy  to  lay  down  a  rule  by  which  to  determine  whether 
certain  charges  are  to  be  treated  as  expense  or  whether 
they  are  to  be  held  in  the  Balance  Sheet  as  representing 
the  cost  of  assets.  From  a  purely  theoretical  view  point 
it  seems  that  any  expenses  necessarily  involved  in  organiz- 
ing a  going  concern  are  properly  assets  of  that  concern, 
as  much  as  are  the  real  estate,  the  machinery,  or  the  stock 
in  trade.  To  the  stockholder  or  proprietor  it  is  part  of 
the  investment  from  which  profit  is  to  come  and  is  hence 
capital  expenditure.  Being  necessary  to  the  establish- 
ment of  such  a  concern  rivals  cannot  spring  up,  unless  they 
too  provide  capital  for  such  a  payment,  and  actuarially 
figured  a  concern  fully  established  is  worth  to  new  oper- 
ators a  premium  equal  to  the  cost  of  organization.  Fur- 
thermore, as  was  most  clearly  brought  out  by  Justice 
North  in  Abstainers  and  General  Insurance  Company 
( [1891],  2  Ch.  125)  any  other  treatment  of  such  payments 
would  have  the  absurd  result,  already  alluded  to,  of  mak- 
ing necessary  an  initial  inroad  into  capital  except  where  a 
company  started  with  a  nominal  surplus. 

The  effect  is  similar  whether  the  payment  of  organiza- 
tion and  other  similar  expenses  is  charged  directly  to  the 
Construction  Account  or  is  carried  along  as  an  inde- 
pendent item.  The  significant  fact  is  that  both  in  theory 
and  practice  the  sums  so  paid  are  held  to  represent  assets. 
Whether  it  is  better  to  show  them  in  increased  cost  of 
plant  or  as  an  independent  item  is  debatable.  German 
legislation  allows  only  the  former,  the  idea  being  that  it  is 
dangerous  to  allow  the  appearance  of  "  fictitious  "  ac- 
counts among  the  assets.  It  also  attempts  to  discriminate 
between  the  preliminary  costs  of  construction  which  are 
to  be  charged  to  the  plant,  and  the  costs  of  organizing  the 
corporation  itself,  which  are  not  to  be  counted  as  an  asset 
at  all.  In  order  to  provide  for  these  latter  it  is  customary 


ASSETS   AND   THEIR   VALUATION  79 

in  Germany  to  issue  the  original  capital  at  a  premium  suf- 
ficient to  cover  the  preliminary  expenses.  But  in  America 
the  preferred  practice  seems  rather  to  favor  listing  Or- 
ganization expenses  and  similar  iteme  as  a  separate  item, 
for  attention  is  thus  called  to  their  somewhat  intangible 
character.  This  custom  also  furthers  the  conservative 
practice  of  annually  charging  off  a  considerable  portion  of 
such  items,  so  that  in  a  few  years  they  disappear  from  the 
inventory  altogether.  But  the  Interstate  Commerce  Com- 
mission provides  in  its  rules  for  classification  of  expendi- 
tures for  road  and  equipment  that  organization  expenses 
shall  be  charged  to  the  construction  or  equipment  account. 
In  the  problems  thus  far  discussed  the  question  has 
been  whether  a  payment  of  a  definite  sum  should  be  con- 
sidered the  cost  of  an  equivalent  asset,  or  merely  the  pay- 
ment of  an  expense.  Another  problem  arises  in  connec- 
tion with  the  purchase  of  property  with  stock  or  bonds 
instead  of  with  cash.  Here  the  difficulty  turns  not  on 
whether  an  asset  has  been  acquired,  but  on  the  uncertain 
value  of  that  which  has  been  given  in  exchange  therefor. 
In  actual  practice  it  is  all  too  customary  to  treat  the  cost 
of  such  property  as  being  equal  to  the  par  of  the  stock 
issued  therefor.  Even  accountants  of  the  highest  standing 
justify  such  a  procedure.  Evidently  this  is  but  one  as- 
pect of  the  much-debated  question  of  stock  watering.  To 
assume  that  the  value  of  the  property  acquired  equals 
the  face  of  the  stock  issued  is  to  assume  that  stock  never 
is,  and  never  can  be  issued  in  excess;  that  there  can  be  no 
stock  watering.  It  argues  in  a  vicious  circle,  for  it  makes 
the  value  of  the  property  dependent  upon  the  amount  of 
stock  issued,  while  capital  is  to  the  accountant  properly 
an  expression  of  the  value  of  the  net  assets  owned,— a  sum 
representing  the  net  wealth  of  the  proprietary  interests. 
If  carried  to  the  logical  extreme,  this  principle  would  re- 
quire that  where  stock  is  sold  at  a  discount  the  cash  re- 


80  MODERN   ACCOUNTING 

ceived  should  be  treated  as  equal  to  the  full  face  value  of 
the  stock,  though  it  is  in  fact  only  a  fraction  of  that  sum. 

It  is  true  that  there  are  difficulties  in  determining  the 
real  value  of  the  property  purchased  with  stock,  and  stat- 
utes and  courts  have  doubtless  been  wise  in  refusing  to 
interfere  with  valuations  placed  on  property;  but  because 
the  courts  cannot  detect  the  error  is  no  excuse  for  a  willful 
misstatement  of  the  value  of  the  property  acquired.  The 
Connecticut  law  of  1903,  while  recognizing  that  the  valu- 
ation of  the  property  is  a  function  of  the  directors  and  not 
of  the  courts,  sets  a  high  standard  in  requiring  that  where 
stock  is  issued  for  anything  except  cash  the  "  directors 
shall  make  and  sign  upon  the  record  book  of  the  corpora- 
tion a  statement  showing  particularly  of  what  the  prop- 
erty received  in  payment  for  stock  subscriptions  consists, 
and  that  it  has  an  actual  value  equal  to  the  amount  for 
which  it  is  received."  The  judgment  of  the  directors  is 
properly  made  final,  but  they  are  liable  for  fraud  in  over- 
valuation. Less  complete  is  the  provision  made  in  other 
statutes  that  the  accounts  of  the  company  shall  clearly 
show  that  certain  property  was  acquired  in  exchange  for 
stock  but  without  implying  an  equivalence  in  actual  value. 
This  subject  is  discussed  more  fully  in  Chapter  IX. 

3.  What  is  the  basis  of  revaluation? 

Having  accepted  the  principle  that  the  original  valua- 
tion of  assets  should  not  exceed  the  cost  price,  and  having 
noticed  the  practical  and  theoretical  difficulty  in  deter- 
mining the  exact  cost  price,  there  remains  the  more  impor- 
tant question  as  to  subsequent  revaluations  of  assets. 
Shall  they  be  put  down  at  the  original  acquisition  price 
or  at  some  other  valuation?  If  at  some  other  value,  shall 
it  be  the  current  market  price,  the  present  value  to  the 
concern,  or  the  price  they  would  bring  in  liquidation  ?  The 
general  principle  which,  with  various*  applications,  is  now 
universally  accepted,  is:  The  inventory  should  be  on  the 


ASSETS   AND   THEIR   VALUATION  81 

basis  of  the  value  of  the  assets  to  the  present  holders  as  a 
"  going  concern."  The  proper  value  is  that  which  they 
have  to  the  holding  concern,  and  not  that  which  they  might 
have  to  other  persons,  whether  these  persons  are  ordinary 
customers,  or  those  who  might  bid  in  the  assets  at  a  liqui- 
dation sale.  The  value  is  that  which  they  have  to  the 
company  as  then  existing  and  not  to  a  company  in  the 
hands  of  a  receiver,  or  one  closing  up  its  accounts  and 
going  out  of  business.  It  is  true  that  in  the  case  of  cor- 
poration this  represents  the  interests  of  the  stockholders 
rather  than  those  of  the  creditors.  Yet  it  is  little  exag- 
geration to  say  that  if  all  assets  were  listed  at  the  value 
which  they  would  realize  at  forced  liquidation,  no  Balance 
Sheet  would  show  solvency.  Valuation  on  such  a  basis 
would,  therefore,  be  absurd,  and  the  general  principle 
must  be  adopted  that  the  basis  of  inventory  values  is  the 
present  value  of  the  asset  to  the  holders  as  a  "  going  con- 
cern. "  To  this  rule  there  may  be  exceptions  or  modifica- 
tions, mostly  introduced  for  the  sake  of  preventing  a  self- 
deceiving  exaggeration  of  values. 

This  leads  to  another  distinction  of  great  importance, 
that  between  "  fixed  "  and  "  circulating  "  assets.  It  is 
impossible  to  draw  a  sharp  and  absolute  line  between  these 
two  classes,  but  in  general  the  differentiation  is  easily 
made.  By  fixed  assets  are  meant  those  which  are  bought 
for  permanent  or  long-continued  use,  by  circulating  assets 
those  whose  use  is  relatively  short  or  which  are  purchased 
for  resale  as  merchandise.  There  is  coming  to  be  recog- 
nized a  difference  in  the  basis  of  valuation  of  these  two 
classes  of  assets,  which  permits  much  greater  latitude  in 
regard  to  fixed  assets  than  is  allowed  concerning  circulat- 
ing assets.  In  general  it  is  considered  legitimate  to  con- 
tinue fixed  assets  at  their  cost  despite  a  subsequent  decline 
in  their  value.  But  in  valuing  circulating  assets  regard 
must  be  had  to  current  values,  although  "there  is  some 


82  MODERN  ACCOUNTING 

question  as  to  whether  the  market  value,  even  of  circulat- 
ing assets  can  be  accepted  where  that  exceeds  the  original 
cost.1  Here  again  the  governing  principle  is  that  of  the 
"  going  concern."  A  piece  of  land,  for  instance,  is  pur- 
chased at  a  fair  price  for  the  purpose  of  erecting  a  fac- 
tory. Its  services  are  presumably  perpetual  and  undi- 
minishing;  the  value  to  the  company  was,  in  the  first  in- 
stance, represented  by  its  full  cost  price ;  its  services,  and 
hence  its  value  to  the  going  concern,  are  the  same  as  before. 
It  is  therefore  proper  to  continue  in  the  inventory  the  cost 
price  of  the  land  quite  irrespective  of  changes  in  its  market 
value  whether  that  be  greater  or  less  than  the  cost.  The 
market  price,  evidently,  can  never  be  realized  so  long  as 
the  land  is  still  used  as  a  factory  site,  the  abandonment  of 
the  factory  means  ordinarily  that  the  enterprise  ceases  to 
be  a  going  concern.  To  be  sure  the  factory  site  might  con- 
ceivably be  sold  and  a  less  expensive  one  be  bought  in  its 
stead,  but  this  implies  recognition  of  a  double  set  of  un- 
realized conditions  and  is  too  vague  for  embodiment  in 
formal  accounts.  Changes  in  the  market  value  of  an  abso- 
lutely fixed  asset,  such  as  land,  railroad  bed,  or  water 
rights,  may  be  ignored  on  the  principle  that  such  changes 
do  not  affect  the  value  of  the  going  concern.  This  is  most 
clearly  seen  in  the  case  of  land,  but  it  is  equally  applica- 
ble to  any  form  of  fixed  asset  provided,  of  course,  that 
allowance  is  made  for  its  necessary  maintenance  and  re- 
newal. 

A  corollary  of  the  foregoing  is  that  mere  fluctuations 
in  value  in  contradistinctions  to  permanent  change  of 
value,  may  be  ignored.  This  is  theoretically  correct,  for 
fluctuations  so  transitory  as  to  be  included  within  the 
period  during  which  the  company  holds  the  given  asset  are 
analogous  to  changes  in  the  value  of  a  fixed  asset.  If  raw 
material  is  bought  in  July  and  the  finished  goods  are  to  be 

1  See  Chapter  V. 


ASSETS   AND   THEIR   VALUATION  83 

marketed  during  the  following  June,  the  oscillations  of 
price  within  that  period  need  have  no  effect  on  the  value 
of  the  material  in  the  manufacturer's  hands.  To  take 
account  of  a  temporary  rise  or  fall  in  a  December  in- 
ventory in  such  a  case  would  perhaps  be  erroneous;  cer- 
tainly so  if  it  were  known  that  the  normal  price  would 
again  appear  before  the  year's  end.  But  in  practice  the 
principle  is  difficult  of  application,  because  of  the  impos- 
sibility of  determining  which  changes  in  price  are  mere 
temporary  fluctuations  and  which  are  more  permanent 
alterations  in  value.  It  is,  however,  of  importance  in 
application  to  the  fluctuation  in  the  market  price  of  invest- 
ments, although  here,  as  is  shown  in  the  next  chapter,  con- 
servative practice  justifies  a  less  logical  treatment.  . 

Another  corollary  needs  mentioning.  If  changes  in  the 
market  value  of  an  unchanging  asset  need  not  be  reck- 
oned the  converse  is  true.  Actual  changes  in  the  use  value 
of  a  fixed  asset,  a  machine  for  instance,  must  be  reckoned, 
even  though  to  the  eye  the  machine  remains  unchanged. 
In  technical  terms,  while  fluctuations  in  fixed  assets  may 
be  ignored,  depreciation  must  always  be  considered.  This 
is  true  whether  there  is  actual  physical  deterioration  or, 
as  in  the  case  of  a  patent  right  or  a  terminable  leasehold, 
the  decline  is  due  to  the  approach  of  the  time  when  the 
present  asset  will  cease  to  have  value.  The  three  rules  cf 
appraisal  of  general  application  are  therefore:  (1)  The 
value  to  be  taken  in  the  inventory  is  not  the  liquidation 
value,  but,  that  to  a  going  concern;  (2)  Changes  in  market 
value  of  fixed  assets  may  be  ignored;  (3)  Depreciation 
must  always  be  taken  into  account. 

In  all  the  foregoing  discussion  it  has  been  assumed  that 
the  purpose  of  accounting  is  to  present  the  facts  fully  and 
without  reservation ;  but  argument  is  sometimes  made  that 
the  statement  set  forth  in  the  Balance  Sheet  does  not  even 
profess  to  be  true ;  indeed,  that  a  variation  from  the  truth, 


84  MODERN  ACCOUNTING 

provided  only  that  it  understates  the  wealth  of  the  con- 
cern, is  really  a  merit  rather  than  a  fault.  This  view  has 
formally  been  set  forth  in  a  recent  English  case  where  the 
court  stated  that  "  The  purpose  of  the  Balance  Sheet  is 
primarily  to  show  that  the  financial  position  of  the  com- 
pany is  at  least  as  good  as  there  stated,  not  to  show  that  it 
is  not  or  may  not  be  better. ' ' 1 

This  view  is  frequently  supported  by  theoretical  writers 
and  has  the  further  sanction  which  comes  from  the  prece- 
dent set  by  conservative  corporations  in  all  lands.  Thus 
it  has  been  argued  that  an  undervaluation  improves  the 
economic  position  of  the  corporation,  that  it  prevents  the 
danger  of  fictitious  dividends,  and  that  "  absolute  truth 
in  the  Balance  Sheet  is  not  only  not  demanded  by  law  but 
is  in  itself  undesirable. ' '  For  precedents  may  be  cited  the 
Bank  of  England  which  omits  from  its  statement  its  land 
and  building,  which  are  certainly  worth  many  millions; 
the  practice  common  among  German  companies  of  listing 
their  real  estate  and  sometimes  their  other  fixed  plant  at 
the  nominal  sum  of  one  mark;  and  the  tendency  among 
American  railways  to  mark  down  the  valuation  placed  on 
the  road  whenever  large  earnings  make  that  possible. 

In  so  far  as  the  undervaluation  of  certain  assets  ic 
merely  an  attempt  to  secure  a  more  truthful  conspectus 
of  the  entire  situation,  the  action  may  be  justified.  An 
argument  that  however  truthful  one's  intentions  may  be, 
he  is  almost  sure  to  overestimate  the  value  of  his  own  pos- 
sessions, and  therefore  after  having  determined  what  he 
really  thinks  they  are  worth,  his  results  will  be  more  accu- 
rate if  he  arbitrarily  writes  off  certain  sums,  is  not  without 
force.  But  to  state  that  an  absolute  understatement  is 
praiseworthy  neglects  the  fact  that  fraud  may  surely  be 
perpetrated  in  that  manner ;  and  while  the  reaction  against 
overvaluation  is  but  natural  and  in  general  healthful,  it 

>  Newton  v.  Birmingham  Small  Arms  Co.  [19061  2  Ch.  378. 


ASSETS   AND   THEIR   VALUATION  85 

seems  a  mistake  to  overlook  the  value  of  accuracy  and  to 
cease  to  hold  it  up  as  the  goal  of  accounting.  Time  was, 
and  that  not  long  since,  -when  even  the  Supreme  Court  of 
the  United  States  stated  that  there  is  but  little  danger 
that  any  board  of  directors  will  ever  understate  the  value 
of  the  assets,  thereby  also  underestimating  the  profit,  the 
temptation  being  in  the  opposite  direction.1  But  certain 
notorious  bear  operations  in  the  stock  exchanges  show  that 
the  unforeseen  has  frequently  happened,  and  the  under- 
valuation of  assets,  with  its  accompanying  understatement 
of  profits  and  establishment  of  a  secret  reserve,  if  the  lesser 
of  two  evils,  nevertheless  falls  far  short  of  the  ideal  stand- 
ard of  accounting. 


BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  IV 

DICKSEE,  L.  R.     Auditing.     American  edition,  edited  by  R.  H. 

Montgomery,     pp.  160  ff.     New  York,  1905. 
HERE,  J.  P.     The  Appreciation  of  Assets.     When  is  it  legitimate? 

Journal  of  Accountancy,  III,  p.  1. 
PIXLEY,  F.  W.     Auditors,  their  Duties  and  Responsibilities.     I, 

Chapter  XI.     Ninth  edition.     London,  1906. 
REHM,  H.     Die  Bilanzen  der  Aktiengesellschaften.    pp.  693-790. 

Munich,  1903. 
SIMON,  H.  V.    Die  Bilanzen  der  Aktiengesellschaften.    pp.  289-322. 

Berlin,  1899. 

For  arguments  in  favor  of  valuing  assets  at  their  liquidation 
value,  see: 

ARNOLD,  H.  L.     The  Complete  Cost-keeper,  pp.  358-359.     New 

York,  1900. 
NORRIS,    H.   M.     Machine-tool   Depreciation   as   an   Element   of 

Manufacturing  Cost.     Engineering  Magazine,  XVI,  pp.  958- 

959. 

1  Union  Pacific  R.  R.  Co.  v.  U.  S.  99  U.  S.  402. 


CHAPTER   V 

THE   VALUATION   OF   PARTICULAR   ASSETS 

IN  the  light  of  the  norms  laid  down  in  the  preceding 
chapter  the  problem  of  the  proper  valuation  of  various 
kinds  of  assets  may  be  considered.  These  may  conven- 
iently be  grouped  into  certain  classes:  Land,  Buildings, 
Machinery,  Investments,  Mercantile  Credits,  and  Merchan- 
dise. 

LAND 

What  has  been  previously  said  in  regard  to  fixed  assets 
generally,  applies  preeminently  to  land  where  that  is  held 
for  the  uses  of  the  company.  The  rule  here  is  that  land 
for  permanent  holding  may  be  held  at  its  cost  despite  a 
decline  or  rise  in  its  market  value.  Legal  authority  for 
this  view  is  given  in  Bolton  v.  Natal  Land  and  Coloniza- 
tion Co.,  Lim.  ([1892],  2  Ch.  124)  where  the  court  held 
not  only  that  a  company  need  not  bring  into  its  accounts 
the  increase  or  decrease  in  the  value  of  its  lands  but  that, 
at  least  so  far  as  it  affects  the  showing  of  profits,  it  is  not 
right  so  to  do. 

Occasionally,  however,  a  question  may  arise  as  to  what 
is  the  cost  of  the  land.  Difference  of  opinion  arises  as  to 
the  treatment  of  legal  fees  connected  with  the  examination 
and  recording  of  title.  Practice  seems  to  favor  adding 
these  to  the  price  paid  in  determining  the  cost,  but  the 
high  authority  of  Pixley  is  against  such  a  practice.  The 
arguments  previously  given  regarding  organization  ex- 
penses support 'the  current  practice. 

Where  a  purchase  mortgage  has  been  given  in  partial 

86 


VALUATION   OF   PAKTICULAK   ASSETS         87 

payment  of  land  it  is  sometimes  the  custom  to  add  inter- 
est paid  on  the  mortgage  to  the  value  of  the  land ;  but  this 
is  unjustifiable  for  the  interest  is  not  a  part  of  the  cost  of 
acquisition  nor  does  it  represent  any  additional  value  ac- 
quired, and  even  though  it  were  parallel  to  an  accretion 
in  value  (an  assumption  far  from  true),  appreciation  of  a 
fixed  asset  is  not  to  be  booked. 

Property  acquired  not  for  permanent  use  but  for  resale 
is  analogous  to  merchandise  bought  by  a  trader.  Where 
the  land  requires  improvement,  as  where  a  large  tract  is 
purchased  to  be  provided  with  sewers,  streets,  gas  and 
water  pipes,  sidewalks  and  other  improvements,  with  the 
expectation  of  subdividing  and  selling  it  in  small  parcels; 
it  is  in  almost  the  same  category  as  raw  material  bought 
by  a  manufacturer  to  be  used  in  producing  his  finished 
commodity.  In  such  cases  the  principles  applying  to  the 
valuation  of  merchandise  and  of  partly  finished  manufac- 
tures respectively  are  to  be  applied  to  the  valuation  of 
the  land.  The  expenditures  actually  incurred  in  acquir- 
ing the  land,  including  those  incident  to  bringing  it  into 
the  desired  form  for  sale,  may  properly  be  considered  as 
entering  into  the  value  at  any  time  during  the  process; 
but  it  is  incorrect  to  add  any  sum  representing  an  esti- 
mated appreciation.  By  some  authorities  interest  actu- 
ally paid  on  a  purchase  mortgage  during  the  improve- 
ment period  may  be  added  to  the  value  of  the  land,  but 
interest  at  a  rate  which  it  is  estimated  would  normally 
have  accrued  on  a  similar  sum  loaned  out,  may  not  be 
added.  This  makes  the  treatment  of  interest  payments 
on  land  where  the  land  is  being  worked  up  into  a  market- 
able commodity  similar  to  that  of  interest  paid  during 
construction  of  a  railroad.  But  the  better  practice  is 
against  such  a  marking  up  of  the  value  of  land  designed 
for  sale.  That  there  is  no  absolute  criterion  universally 
adopted  is  shown  by  the  fact  that  in  Germany  the  laws 


88  MODERN   ACCOUNTING 

permit  interest  paid  to  be  added  to  the  value  of  real  estate 
held  by  a  company  with  limited  liability  (Gesellschaft  m. 
b.  H.)  but  does  not  allow  this  to  be  done  where  the  owner 
is  an  ordinary  corporation.  (Aktiengesellschaft.) 

While  the  improvement  of  a  large  tract  of  land  is 
analogous  to  the  manufacture  of  commodities,  the  fact  that 
the  various  small  parcels  of  land  differ  widely  in  value 
makes  the  estimation  of  the  value  of  the  unsold  portion 
of  a  tract  of  land  a  little  more  difficult  than  the  appraisal 
of  the  unsold  portion  of  the  stock  of  identical  commodities. 
A  tract  may  have  been  purchased  and  divided  into  say  one 
hundred  lots,  half  of  which  are  sold.  The  presumption  is, 
however,  not  at  all  that  the  remaining  half  represents  one 
half  of  the  original  cost.  The  proper  basis  is  to  appraise 
the  value  of  each  separate  parcel  at  the  market  price,  and 
to  assign  to  it  as  the  inventory  value  that  proportion  of 
the  total  cost  which  its  appraised  value  bears  to  the  total 
appraisal.  Thus  if  a  block  of  land  is  bought  and  divided 
into  one  hundred  lots  at  a  cost  including  improvements  of 
$150,000,  the  sum  of  the  appraised  value  of  the  one  hun- 
dred lots  after  improvements  have  been  completed  may 
be  $200,000,  the  appraised  value  of  lot  A  because  of  its 
superior  location,  being  $4,000;  but  the  value  to  be  as- 
signed to  A  in  the  inventory  (some  of  the  lots  having 
been  sold)  is  not  $1,500,  nor  $4,000,  but  4,000  X  $150,000 

or  $3,000.  200,000 

BUILDINGS 

The  principle  here  is  not  different  from  that  applica- 
ble to  land  although  there  are  differences  in  detail.  These 
arise  from  the  difference  in  the  cost  of  maintenance,  and 
the  certainty  that  in  most  cases  even  after  liberal  re- 
newals the  buildings  will  some  time  be  worn  out  or  an- 
tiquated. To  continue  the  original  cost  it  must  be  certain 


VALUATION   OF   PARTICULAR   ASSETS         89 

that  all  necessary  repairs  have  been  charged  to  expense. 
This  is  more  difficult  because  during  a  course  of  years  it 
is  likely  that  additions  and  improvements,  as  well  as  nor- 
mal repairs,  will  be  made.  Where  an  improvement,  say 
the  introduction  of  an  electric  lighting  plant,  or  an  addi- 
tion to  the  building  has  been  made,  it  is  difficult  to  deter- 
mine how  much  of  the  money  thus  expended  is  to  be  con- 
sidered as  the  cost  of  an  additional  amount  of  building 
and  how  much  is  a  mere  repair  or  restoration  of  part  of 
the  old  building.  The  ever  difficult  task  of  distinguishing 
between  so-called  "  capital  and  revenue  expenditures" 
must  be  accomplished;  and,  after  all  that  is  done,  allow- 
ance must  be  made  for  the  inevitable  progress  toward  the 
time  when  the  building  will  no  longer  be  serviceable  for 
the  purposes  of  the  company. 

MACHINERY,  TOOLS,  ETC. 

Valuation  at  cost  price,  with  proper  allowance  for 
depreciation  is  evidently  the  correct  basis.  But  it  should 
be  borne  in  mind  that  much  of  the  equipment  of  the  fac- 
tory is  of  very  temporary  use,  and  a  valuation  near  the 
cost  would  be  far  from  correct.  Such  articles  as  patterns, 
in  a  short  time  may  have  practically  no  value.  Lasts  in 
a  shoe  factory  are  a  very  large, item  and  accumulate  with 
changes  in  fashion  at  an  appalling  rate.  Much  care  must 
be  exercised  if  the  Balance  Sheet  is  to  escape  being  over- 
loaded with  what  represents  a  real  cost  but  is  no  longer 
a  real  asset.  Where  the  machinery  used  is  not  purchased 
but  made  within  the  factory  itself,  as  is  very  often  the 
case,  the  value  is  of  course  not  the  price  which  that 
machinery  would  bring  in  the  open  market  but  the  actual 
manufacturing  cost. 

The  inventory  value  of  machinery  may  properly  include 
its  cost  of  installation  in  the  factory.  (Whittaker  v. 


90  MODEEN   ACCOUNTING 

Amwell  Nat.  Bank.  52  N.  J.  Eq.  400.  (1894)).  This  is 
in  harmony  with  the  general  principle  that  the  inventory 
has  to  do  with  the  value  to  the  going  concern. 

INVESTMENTS 

In  the  foregoing  pages  there  has  been  only  one  objective 
criterion  of  value,  cost  j>rice,  and  that  is  confessedly  faulty 
for  it  refers  to  an  earlier  and  not  to  the  present  day  val- 
uation. But  for  investments  that  are  quoted  in  a  stock 
exchange  there  is  a  definite  objective  determination  of 
to-day's  value.  The  objection  to  making  an  independent 
valuation  of  one's  lands  or  houses  is  that  there  may  be  an 
unconscious  overvaluation,  or  that  an  intentional,  and  per- 
haps fraudulent,  overvaluation  cannot  easily  be  detected. 
But  where  there  is  a  definitely  ascertainable  market  price, 
known  to  the  public  and  fixed  by  outside  interests,  the 
objections  just  urged  do  not  apply  and  it  would  seem  that 
it  might  be  safe  and  justifiable  to  ignore  altogether  the 
cost  price,  and  alter  the  book  value  with  every  fluctuation 
in  the  market  price. 

But  if  the  securities  are  real  investments,  and  not  the 
stock  in  trade  of  a  banker  the  objection  at  once  arises  that 
there  can  be  no  availing  of  the  market  price  so  long  as  the 
securities  are  thus  held.  .For  instance  a  National  Bank 
buys  government  bonds  at  par,  the  holding  of  a  minimum 
amount  of  such  bonds  being  a  prerequisite  to  the  bank 
doing  any  business.  The  bonds  bought  at  par  may  rise 
to  110  per  cent.,  or  conceivably  fall  below  par,  but  it  is 
evidently  impossible  for  the  bank  to  realize  this  increase 
in  value,  nor  can  it  suffer  a  loss  while  it  continues  as  a 
going  concern.  To  list  the  bonds  at  more  or  less  than  cost 
price  would,  for  the  ordinary  purposes  of  the  bank,  be 
futile.  It  is  true  that  if  the  bank  went  into  liquidation 
the  variation  would  be  realized,  but  to  take  account  of 


VALUATION   OF   PARTICULAR   ASSETS         9! 

that  possibility  is  counter  to  the  generally  accepted  rule 
that  assets  are  to  be  inventoried  at  their  value  to  the  going 
concern. 

The  bank  may  furthermore  buy  other  bonds  to  serve 
as  the  basis  for  additional  circulation.  These  bonds,  above 
the  minimum  required  in  any  event,  may  be  sold  but- 
only  where  the  covered  circulation  is  withdrawn.  The 
impossibility  of  realizing  an  appreciation  of  these  addi- 
tional bonds  is  less  absolute  than  in  the  case  of  the  re- 
quired minimum  holding,  but  here  again  the  principle  of 
the  going  concern  applies.  The  bank  cannot 'continue  the 
note-issuing  function  and  at  the  same  time  realize  on  the 
bond  premium.  So  here  too  the  variation  in  market  price 
seems  to  be  of  no  import.  The  same  conditions  exist  in 
regard  to  holdings  of  stock  acquired  by  a  railroad  to  give 
it  control  in  the  management  of  another  road  or  of  some 
allied  enterprise.  The  market  price  of  this  stock  may  vary, 
but  such  changes  in  value  cannot  be  realized  by  the  pur- 
chasing company  while  it  still  continues  to  exercise  the 
function  for  which  it  acquired  the  stock— that  is,  to  con- 
trol the  other  road. 

In  many  cases,  however,  there  is  no  such  indissoluble 
connection  between  holding  some  given  security  and  the 
maintenance  of  the  business.  Securities  are  held  not  be- 
cause required  by  some  provision  of  law,  not  for  the  sake 
of  controlling  business  nor  even  for  the  sake  of  income 
alone.  It  is  desirable  to  hold  some  funds  as  air  available 
reserve  against  emergencies  and  a  low-rate  marketable 
security  is  somewhat  less  expensive  and  almost  as  service, 
able  a  reserve  as  the  bare  cash.  The  sale  of  such  securities 
at  the  market  price  would  not  at  all  interfere  with  tho 
business  of  the  concern ;  and  the  appreciation,  as  shown  by 
the  market  price,  indicates  merely  that  the  reserve  to-day 
really  contains  more  than  the  sum  that  was  originally 
invested.  May  not  the  inventory  here  rely  solely  on  the 


92  MODERN   ACCOUNTING 

market  quotation?  Strict  consistency  would  seem  to  give 
an  affirmative  answer.  On  the  other  hand  the  .present 
price  is  only  one  point  in  a  fluctuating  scale  of  market 
prices  and  there  is  no  ground  for  assuming  that  it  will 
be  realized.  If  it  has  risen  there  is  at  least  a  possibility 
that  it  will  fall.  The  emergency  that  will  call  for  the  sale 
of  the  securities  is  likely  to  be  at  the  time  of  a  monetary 
stringency  and  hence  of  low  prices,  so  that  a  high  valua- 
tion would  be  purely  illusory.  The  attitude  of  statute 
law  and  of  the  courts  on  this  point  is  that  where  the  secur- 
ities are  permanent  holdings,  disregard  of  market  prices 
is  proper  whether  these  prices  are  above  or  below  cost. 
This  is  clearly  set  forth  by  the  English  courts  in  Verner  v. 
The  General  and  Commercial  Investment  Trust  Limited. 
([3894]  2  Ch.  239)  where  the  distinction  is  made  between 
securities  held  as  investments  for  the  sake  of  the  income, 
and  those  carried  as  the  stock  in  trade  of  a  dealer  in  invest- 
ments. In  France,  too,  the  Bank  of  France  holds  all  gov- 
ernment securities  which  were  bought  for  permanent  hold- 
ing at  cost  price  irrespective  of  market  quotations.  In 
Germany,  however,  the  law  provides  that  the  market  price 
is  to  be  taken  except  where  it  is  higher  than  cost  price, 
which  is  equivalent  to  saying  that  of  the  two  prices,  cost 
and  quoted  market  price,  the  lower  is  always  to  be  taken 
as  the  basis  of  the  inventory.  This  provision  of  the  Com- 
mercial Code  leads  therefore  toward  conservatism  at  the 
expense  of  logical  consistency.  In  Austrian  law  the  quoted 
market  price  is  always  to  be  taken  whether  higher  or 
lower  than  the  cost.  The  general  practice  of  conservative 
American  accountants,  especially  in  banks,  insurance  com- 
panies and  other  fiduciary  institutions,  is  in  line  with 
German  law,  and  favors  marking  down  the  investments 
when  the  market  price  is  below  the  cost  price,  but  opposes 
taking  recognition,  except  in  an  explanatory  footnote  to 
the  Balance  Sheet,  of  the  appreciation  due  to  a  rising 


VALUATION   OF   PARTICULAR   ASSETS         93 

market.  Thus  the  New  York  Banking  Department  asks 
banks  to  charge  off  the  excess  of  book  value  over  market 
value  of  securities,  but  where  the  difference  is  slight  or  sup- 
posed to  be  a  mere  temporary  fluctuation,  no  attention  is 
paid  to  the  variation.  Occasionally  in  America  both  prac- 
tice and  law,  as  for  instance  the  Maine  Savings  Bank  Law, 
adopt  an  even  less  logical  rule  that  securities  may  not 
be  listed  above  par  even  though  they  cost  a  considerable 
premium,  but  if  costing  less  than  par  they  are  to  be  listed 
at  cost. 

In  the  justification  of  listing  permanent  holdings  at 
cost  it  has  been  assumed  that  the  lapse  of  time  has,  in  itself, 
worked  no  change  in  the  serviceability  of  the  security. 
This  is  true  only  in  case  of  permanent  securities  such  as 
corporation  stock  in  this  country,  or  the  perpetual  an- 
nuities used  by  most  foreign  governments.  Time  differ- 
ences may  be  ignored  also  in  certain  bonds  which  while 
due  at  a  definite  time  have  so  long  a  duration  as  to  be 
practically  perpetual,  the  bonds  of  the  West  Shore  Rail- 
road running  475  years  being  an  illustration.  But  wher- 
ever an  ordinary  bond  is  bought  at  a  premium  it  is  to  be 
recognized  that  the  purpose  of  this  premium  is  to  make 
the  nominal  rate  of  interest  conform  to  the  market  rate 
for  the  given  security,  and  is  a  payment  in  lump  sum  to 
offset  the  receipts  from  future  interest  payments  whose 
rate  is  higher  than  the  market  rate.  If  the  current  market 
rate  is  five  per  cent.,  a  six  per  cent,  bond  running  five 
years  will  not  be  worth  as  much  as  a  bond  bearing  the 
same  rate  of  interest  but  running  twenty  years.  In  one 
instance  there  is,  in  addition  to  the  normal  rate  of  five  per 
cent.,  an  annuity  of  one  per  cent,  running  for  five  years, 
in  the  other  case  the  annuity  runs  twenty  years.  To  con- 
tinue to  list  the  bond  in  successive  annual  inventories  at 
its  cost  price  is  incorrect.  At  the  time  of  purchase  an  esti- 
mate is  made  of  what  rate  the  bond  nets  the  investor,  the 


94  MODEKN   ACCOUNTING 

three  factors  of  time,  rate  and  price  being  considered. 
Thus  if  112.46  per  cent,  is  paid  for  a  bond  running  twenty 
years  and  paying  annually  six  per  cent,  interest  it  nets 
the  investor  five  per  cent.  In  each  successive  inventory 
the  bond  should  be  listed  not  at  112.46  but  at  the  price  at 
which  the  bond  with  its  shortened  duration  would  net  five 
per  cent.,  that  is,  at  112.08,  111.69  and  so  on  until  the 
nineteenth  year  when  its  value  is  100.95.  Or,  looking  at 
it  in  another  way,  the  annuity  of  one  per  cent,  running 
for  twenty  years  was  estimated  to  be  worth  12.46  per  cent. 
It  is  clearly  faulty  to  consider  a  similar  annuity  running 
nineteen,  and  a  constantly  diminishing  number  of  years,  as 
worth  the  same  price;  but  it  should  be  estimated  on  the 
same  basis,  that  is,  at  such  a  price  that  it  continually  yields 
the  holder  five  per  cent,  interest.  The  figures  for  the 
valuation  of  bonds  of  different  rates  and  maturities  are 
easily  obtained  from  tables  of  Bond- Values,  many  of  which 
are  in  the  market. 

The  formula  by  which  these  values  are  obtained  is 
derived  as  follows : 

Letting : 

Vn  =  the  present  value  of  a  bond  running  for  n  inter- 
est periods. 

I  =  the  amount  of  interest  paid  on  each  $100  at  each 
interest  payment. 

i  =  the  rate  of  interest  to  be  yielded  the  holder  for  each 
interest  period. 

It  is  clear  that  the  present  value  of  the  bond  is  made  up 
of  a  series  of  values  composed  of  each  coupon  maturing 
at  successive  periods  and  of  the  principal,  assumed  to  be 
$100,  due  at  the  end  of  the  n  years.  But  the  first  coupon 
due  in  one  period  (for  convenience  the  period  will  be 

assumed  to  be  a  year)  has  for  its  present  value  -    — ,  the 


VALUATION   OF   PARTICULAK   ASSETS          95 

I 

coupon  due  in  two  years  is  worth  at  present  that 

I  d  +  i)2 

in  three  years —  and  so  on  until  the  last  coupon  which 

I 

is  worth    : — .      Adopting   the    conventional   symbol 

v  — then  the  entire  series  of  coupons  is  worth  at 

1  -H  1  —  vn 

present  I  (v  -f  v2  +  v3  -f  v4  .  .  .  +  vn.)  or  I : .    The 

i 

principal  of  $100,  also  due  in  n  years,  is  worth  100  vn  so 

1  —  vn 

that  the  equation  reads :   Vn  —  I \-  100  vn.     This, 

i 

for  the  bond  used  as  illustration  in  the  text,  would  be 

1 

"  (1.05)20  100 


.05  (1.05) 20 

In  other  words  the  present  value  of  the  bond  represents 
two  sums:  One  the  present  value  of  an  annuity  (I)  fur- 
nished by  the  series  of  coupons,  running  for  n  years,  the 
other  the  present  value  of  the  principal  due  in  n  years. 

The  same  result  is  gained  by  considering,  in  the  for- 
mula, only  the  excess  of  interest  (over  the  market  rate) 
which  the  bond  pays.  A  bond  bearing  five  per  cent,  in- 
terest would,  of  course,  sell  at  par  when  the  market  rate 
is  also  five  per  cent.  A  bond  paying  a  higher  rate  of  in- 
terest will  be  worth  a  premium  equal  to  the  present  value 
of  an  annuity  whose  annual  installment  is  the  difference 
between  the  nominal  rate  of  interest  and  that  taken  as  the 
basis  of  calculation. 

The  formula,  derived  in  a  manner  similar  to  that  given 
above,  is  •                                             1  —  vn 
P=  (I  — 1001).  .  : — , 


96 

or,  substituting  the  values  used  above: 

1 


1— 


(1.05) 20 

P=  (6-5) 

.05 

or  the  value  at  five  per  cent,  of  a  twenty-year  terminable 
annuity  of  $1.00.  Where  the  nominal  rate  of  interest  is 
less  than  that  taken  as  the  basis  the  result  will,  of  course, 
show  a  discount  instead  of  a  premium. 

The  value  of  the  bond  at  the  time  of  each  successive 
inventory  is  obtained  by  merely  changing  the  value  of  n 
so  that  it  equals  the  number  of  interest  periods  still  re- 
maining before  maturity. 

Interest  is  more  customarily  paid  semiannually.  "Where 
that  is  the  case  the  same  formula  is  used  but  n  represents 
the  number  of  half-year  periods,  and  i  of  course,  the  rate 
to  be  obtained  not  for  the  year  but  for  the  half-year.  Thus 
for  a  twenty-year  six  per  cent,  bond  with  interest  payable 
semiannually  n  would  be  40,  i  would  be  .025  and  I  would 
be  3.  Tables  are  published  for  bonds  with  annual,  semi- 
annual and  quarterly  interest  and  also  to  show  the  price 
at  which  a  bond  bearing  interest  annually  would  be  as 
remunerative  as  one  bearing  interest  semiannually,  etc. 

Logically  bonds  bought  at  a  discount  should  similarly 
be  treated  by  being  marked  up  in  value  with  each  annual 
approach  toward  maturity.  If  a  six  per  cent,  bond  is 
worth  112.46,  that  is,  it  nets  five  per  cent.,  a  four  per 
cent,  bond  would  have  an  actuarial  value  (its  market  value 
would  probably  vary  somewhat  from  this)  of  87.54.  That 
is,  the  bond  bearing  a  nominal  rate  one  per  cent,  above 
the  net  rate  of  five  per  cent,  is  worth  a  premium  of  12.46 
per  cent. ;  one  whose  nominal  rate  is  one  per  cent,  below 
the  normal  should  sell  at  a  discount  of  12.46  per  cent.  To 
continue  to  list  the  latter  bond  at  the  purchase  price  is 
mathematically  incorrect,  for  at  maturity  the  holder  will 


VALUATION"   OF   PAETICULAE   ASSETS          97 

receive  not  only  the  regular  payment  of  interest  and  his 
invested  principal  of  87.54  but  an  additional  sum  of  12.46, 
the  full  face  of  the  bond  being  then  payable.  The  value 
of  a  promise  to  pay  this  sum  of  12.46  increases  as  the  date 
for  its  payment  draws  near,  and  a  correct  valuation  would 
therefore  demand  that  each  year  the  bond  purchased  at  a 
discount  should  be  marked  up  just  as  the  bond  purchased 
at  a  premium  should  annually  be  marked  down. 

But  accounting  practice  has  not  fully  accepted  this 
principle.  In  many  cases  the  annual  writing  off  of  pre- 
mium paid  is  justified,  but  there  is  hesitation  at  writing 
up  the  bond  bought  at  a  discount.  This  is  largely  an  evi- 
dence of  the  conservative  tendency  which  looks  askance 
at  anything  which  tends  to  swell  the  value  of  assets,  but 
encourages  undervaluation.  Moreover  the  courts  in  the 
apportioning  of  receipts  of  estates  between  the  one  with  a 
life  interest  and  the  remainder-man,  generally  hold  that 
premiums  given  and  received  are  a  part  of  the  corpus  of 
the  estate  and  do  not  enter  into  revenue,  but  that  where  a 
bond  is  bought  at  a  discount  the  tenant  for  life  receives 
only  the  nominal  rate  of  interest ;  and  while  the  rulings  of 
the  courts  in  probate  matters  do  not  necessarily  apply  to 
ordinary  commercial  accounting,  the  practice  in  the  treat- 
ment of  premium  and  discount  on  bonds  is  similar  in 
both  fields. 

Interest  accrued  on  investments  should  be  estimated 
and  shown  on  the  Balance  Sheet.  This  is  not  analogous  to 
taking  recognition  of  an  appreciation  in  market  value,  for 
the  interest  is  earned  and  is  as  much  an  asset  as  the  face 
of  the  bond  itself.  "Whether  interest  accrued  but  not  yet 
due,  or  interest  due  but  not  yet  paid,  may  be  used  as  a 
basis  of  dividends  is  a  question  discussed  in  Chapter  XII. 
But  accounting  practice  uniformly  estimates  interest, 
whether  due  to  or  by  the  company,  even  though  the  law 
may  object  to  a  dividend  in  anticipation  of  its  receipt. 


98  MODERN   ACCOUNTING 


MERCANTILE  CREDITS 

The  holding  of  mercantile  credits— book  accounts,  ac- 
ceptances, promissory  notes,  etc. — being  an  essential  part 
of  .ordinary  commercial  life  they  must  be  treated  somewhat 
differently  from  investments.  They  are  so  clearly  a  part 
of  the  circulating  assets  ( are  '  *  circulating  capital, ' '  to  use 
the  term  employed  by  the  courts)  that  there  can  never  be 
any  justification  for  allowing  them  to  appear  at  more  than 
their  real  value.  The  argument  frequently  made  that 
shrinkage  in  the  real  value  of  fixed  assets,  inasmuch  as  it 
works  no  change  in  the  conduct  of  the  business,  may  be 
ignored  is  not  without  some  plausibility.  But  a  loss  in 
any  of  the  circulating  assets  cannot  be  disregarded.  It 
immediately  manifests  itself  in  reducing  profits  and  must 
appear  in  some  form  in  the  Balance  Sheet. 

For  convenience  Mercantile  Credits  are  entered  and 
carried  on  the  books  at  their  face'  rather  than  at  their 
present  actual  value.  Thus  a  thousand-dollar  note  due 
without  interest  in  sixty  days  appears  in  the  Bills  Receiv- 
able account  at  $1,000  not  at  $990,  leaving  the  adjustment 
to  be  made  through  an  interest  or  discount  account.  This 
is  much  more  convenient  in  checking  over  the  contents  of 
the  bill  portfolio,  and,  unless  a  daily  revaluation  of  the 
notes  is  made,  it  is  also  as  accurate  as  to  list  the  note  at  the 
discounted  value  on  the  day  when  it  is  acquired.  But  when 
a  new  inventory  is  to  be  made  it  is  necessary  to  take  full 
account  of  interest  adjustments. 

The  adjustment  of  interest  is,  however,  a  mere  matter 
of  arithmetic  and  offers  no  problem  in  accounting.  The 
estimate  of  probable  loss  due  to  insolvency  of  debtors,  being 
an  estimate  merely,  is  a  debatable  and  interesting  problem. 
A  company  may  hold  a  thousand  notes  of  customers  aggre- 
gating $100,000,  its  books  showing: 


VALUATION   OF   PARTICULAR   ASSETS 


99 


Dr. 


FORM  34. 

Balance  Sheet. 


Cr. 


Merchandise $140,000 

Bills  Receivable 100,000 

Cash 10,000 

$250,000 


Capital $220,000 

Profit  and  Loss 30,000 


$250,000 


If  some  of  these  notes  are  clearly  worthless  they  should 
at  once  be  stricken  from  the  list  of  assets,  without  waiting 
even  for  the  annual  inventory.  No  justification  can  be 
found  for  retaining  on  the  books  the  note  of  A  for  one  hun- 
dred dollars  if  it  is  known  to  be  worthless.  As  soon  as- 
that  fact  is  manifest  the  note  must  be  eliminated  by  charg- 
ing it  at  once  to  Profit  and  Loss,  or  pending  the  annual 
balance  of  the  books  to  some  subsidiary  account  indicating 
a  loss.  The  accounts  would  then  furnish  the  following: 


Dr. 


FORM  35. 

Balance  Sheet. 


Cr. 


Merchandise $140,000 

Bills  Receivable 99,900 

Cash 10,000 

$249,900 


Capital $220,000- 

Profit  and  Loss 29,900 


$249,900 


Where  there  remains  a  slight  chance  that  the  debt  may 
some  time  be  paid  and  yet  one  on  which  it  is  not  safe  to- 
count,  it  may  be  desirable  to  keep  a  reminder  of  the  debt 
on  the  books  without  appreciably  swelling  the  assets  by 
including  doubtful  debts.  This  is  conveniently  done  by 
charging  off  the  bulk  of  the  note,  but  leaving  a  purely  nom- 
inal sum,  perhaps  one  dollar,  or  even  a  smaller  sum,  as  a 
reminder  that  there  is  still  an  unsettled  claim  outstanding. 

But  a  more  delicate  question  arises  in  connection  with. 


100 


MODERN   ACCOUNTING 


probable  losses  which  have  not  been  made  known.  Of  the 
remaining  999  notes  in  the  assumed  case  no  one  of  the 
makers  has  as  yet  failed,  and  yet  past  experience  shows 
that  it  is  a  certainty  that  some  of  the  notes  will  not  be  paid 
in  full,  and  the  probabilities  are  that  at  least  one  of  them 
will  ultimately  prove  worthless.  Each  one  of  the  notes 
must  in  the  meantime  be  kept  on  the  books  at  the  face 
value,  allowing  the  estimated  shrinkage  to  appear  as  a  re- 
serve for  doubtful  debts.  The  entry  to  be  made  is  to  debit 
Profit  and  Loss  and  credit  Reserve  for  Doubtful  Debts  or 
some  equivalent  account.  In  the  formal  publication  of  the 
Balance  Sheet  this  would  appear  as 


Dr. 


FORM  36. 
Balance  Sheet. 


Cr. 


Merchandise $140,000 

Bills  Receivable..  $99,900 
Less  Allowance 

for  doubtful 

debts 100      99,800 

Cash 10,000 

$249,800 


Capital $220,000 

Profit  and  Loss 29,800 


$249,800 


That  such  allowance  should  be  made  is  not  only  dictated 
by  business  prudence  and  accounting  practice,  but  is  as 
well  commanded  by  the  United  States  Supreme  Court  in 
Providence  Rubber  Co.  v.  Goodyear  (9.  Wall.  788),  and  by 
the  English  courts  In  re  Oxford  Benefit  Building  &  Inv. 
Soc.  (35  Ch.  Div.  502).  The  amount  to  be  allowed  is  to  be 
decided  in  each  individual  case  but  it  certainly  should  not 
be  much  below  what  has  been  generally  accepted  in  the 
specific  business  concerned.  The  basis  of  figuring  is  also 
subject  to  individual  preference;  some  preferring  to  take 
a  percentage  of  gross  sales,  some  a  percentage  of  debts 
outstanding,  still  others  a  percentage  of  credits  given. 


VALUATION   OF   PARTICULAR  ASSETS        101 

"With  business  of  a  constant  character  correct  results  could 
be  reached  as  well  with  one  method  as  another.  But  a 
change  in  the  character  of  the  business  done  would  neces- 
sitate a  change  in  the  rate  adopted.  Thus  if  2  per  cent, 
on  total  sales  was  correct  with  a  business  which  was  50 
per  cent,  cash  it  would  probably  be  insufficient  if  the 
change  in  business  methods  gave  80  per  cent,  of  the  sales 
for  credit  and  only  20  per  cent,  for  cash.  Similarly  an 
increase  in  term  of  credit  granted  would  invalidate  an 
allowance  based  on  debts  outstanding.  And  any  rates 
would  need  to  be  changed  if  there  arose  a  general  panic 
or  other  commercial  disturbance. 

It  is  incorrect  to  list  in  the  Balance  Sheet  merely  the 
excess  of  debts  due  to  the  concern  over  the  amounts  due 
from  it.  The  canceling  of  one  against  the  other  does  not 
exhibit  the  true  condition,  for  the  failure  of  the  concern's 
debtors  to  pay  does  not  at  all  affect  the  necessity  of  pro- 
viding for  the  claims  of  its  creditors.  This,  however,  is 
done  in  the  Balance  Sheet  of  the  Illinois  Central,  but  the 
defect  is  partly  remedied  by  reference  to  statements  giving 
the  detailed  information. 

MERCHANDISE 

General  usage  prescribes  that  merchandise  on  hand 
shall  be  inventoried  at  cost  rather  than  at  selling  price. 
Prudence  further  demands  that  merchandise  which  evi- 
dently cannot  be  sold  except  at  a  loss,  be  marked  down  even 
below  the  cost  price.  I£  one  could  count  not  only  on  good 
faith  but  as  well  on  unbiased  judgment  in  making  inven- 
tories, the  taking  of  the  present  market  value,  instead  of 
the  cost  price  would  not  be  objectionable,  but  rather  to  be 
commended.  Indeed,  the  first  principle  of  valuation  laid 
down  above,  that  of  the  ' '  going  concern  "in  strict  logic 
demands  that  merchandise  for  sale  be  valued  at  the  pres- 


102  MODERN  ACCOUNTING 

ent  selling  price,  with  a  reduction  to  cover  selling  ex- 
penses. A  real  change  having  taken  place  in  selling  value 
the  original  cost  is  of  no  effect,  for  whether  bought  at  a 
high  or  low  cost  its  value  to  the  concern  is  determined  at 
the  normal  price  at  which  it  can  now  be  sold.  But  the 
German  commercial  code,  in  many  respects  a  guide  to  those 
whose  accounting  practices  are  so  free  from  legal  control, 
in  attempting  to  prevent  overvaluation  prescribes  that  the 
cost  price  of  merchandise  must  be  taken,  except  where 
there  is  a  publicly  quoted  price— as  for  instance  for  grain 
in  a  produce  exchange— which  is  lower  than  the  cost  price. 
Logic  perhaps  demands  that  the  quoted  price  should  be 
taken  as  well  when  over  as  when  below  the  cost  price,  but 
this  is  not  permitted  by  German  law,  although  the  Austrian 
law  allows  it  to  be  done. 

American  practice  agrees  with  German  law.  In  one 
important  decision  the  Massachusetts  court,  on  the  con- 
trary, stated  that  depreciation  or  advance  in  the  value  of 
the  stock  unsold  must  be  taken  into  account.1  But  in  this 
particular  case  there  had  been  a  loss  of  merchandise  by  fire 
instead  of  an  appreciation  in  value;  and  it  is  to  be  hoped 
that  this  obiter  dictum  is  not  considered  authoritative. 
In  any  event  the  judgment  of  accountants  is  adverse  to 
such  treatment  of  the  inventory.  The  conservative  rule, 
generally  adopted,  is  that  merchandise  is  to  be  inventoried 
at  cost  except  where  there  is  a  decline  in  value,  in  which 
case  the  lower  value  is  to  be  used. 

In  the  case  of  merchandise  purchased  for  sale  the  cost 
price  ordinarily  can  be  easily  obtained.  There  may,  how- 
ever, be  some  room  for  question  even  here  as  to  what  items, 
if  any,  may  be  added  to  the  quoted  cost  price  for  inventory 
purposes.  It  is  apparent  that  if  two  consignments  be  pur- 
chased one  at  $1,000  c.  i.  f.  and  the  other  for  $990  f.  o.  b. 
the  freight  and  other  charges  on  the  second  consignment 

»  Meserve  v.  Andrews,  106  Mass.  419.     (1871.) 


VALUATION  OF   PARTICULAR   ASSETS        103 

being  just  $10,  it  would  be  illogical  to  list  the  two  lots  at 
different  figures.  In  other  words  the  familiar  principle  of 
valuing  the  goods  to  a  going  concern  applies  here  as  well 
as  in  other  cases.  The  retailer  needs  the  goods  in  his  own 
store  and  the  expenses  of  getting  them  there,  whether  paid 
by  the.  manufacturer  and  included  in  the  cost  price,  or  paid 
by  the  retailer  in  addition  to  the  cost  price  are  legitimately 
included  in  the  inventory  value. 

It  is  sometimes  urged  that  while  cost,  rather  than  sell- 
ing price,  should  be  selected,  it  need  not  be  the  actual  cost 
price  paid,  but  the  price  which  would  need  to  be  paid  at 
the  time  the  inventory  is  taken.  The  clearest  case  is  where 
one  consignment  is  purchased  say  at  $1,000  and  shortly 
after  an  exactly  similar  consignment  is  bought  for  $1,200. 
If  an  inventory  is  taken  while  part  of  the  first  consign- 
ment is  still  unsold,  the  taking  of  the  actual  costs  will 
present,  in  the  inventory,  the  absurdity  of  having  identical 
goods  listed  as  having  different  values.  If  all  are  in- 
ventoried on  the  basis  of  the  later  invoice,  the  profit  which 
thus  appears  is  said  not  to  be  an  unrealized  profit  on 
sales,  but  an  already  gained  profit  on  a  fortunate  purchase. 

The  danger  of  such  a  course  is  apparent.  A  large  stock 
of  unsold  goods  can  be  made  to  show  a  profit  by  a  subse- 
quent purchase  of  a  small  amount  at  a  high  price.  Per- 
haps this  is  purposely  done,  and  an  excessive  price  is  will- 
ingly paid  just  before  inventory  in  order  to  make  a  fair 
showing  to  stockholders.  A  stock  of  100,000  yards,  cost- 
ing and  worth  only  one  dollar  the  yard,  could  by  a  tricky 
purchase  of  100  yards  at  $1.10  yield  an  apparent  profit  of 
$10,000.  Thus  the  safeguard  which  is  found  in  clinging 
to  cost  price  would  be  nugatory  and  the  way  made  easy 
to  the  pleasing  practice  of  creating  profits  by  marking  up 
goods.  To  prevent  this  the  actual  cost  paid  should  be 
taken  despite  the  objection  stated  above. 

In  cases  where  parts  of  the  different  stocks  of  similar 


104  MODERN   ACCOUNTING 

, 

goods,  bought  at  varying  prices,  have  been  sold,  a  still  fur- 
ther  difficulty  arises.  Thus,  to  illustrate,  10,000  bushels 
of  grain  are  bought  in  January  "at  $1.00  a  bushel,  10,000 
in  July  at  $1.20,  and  in  August  5,000  are  sold  at  $1.30. 
If  it  is  assumed  that  the  sale  was  of  the  first  consignment 
there  has  been  a  realized  profit  of  $1,500,  but  only  one- 
third  as  much  if  the  sale  was  of  grain  bought  in  July. 
"Where  the  consignments  are  kept  physically  distinct  the 
proper  treatment  is  apparent;  where  they  are  not  distin- 
guishable the  average  cost  should  be  taken,  thus  showing 
a  profit  of  $1,000.  Evidently  the  average  should  be  the 
weighted  average,  not  the  simple  average  of  prices,  so  that 
a  purchase  of  10,000  bushels  at  $1.00  and  2,000  bushels  at 
$1.20  would  be  treated  in  the  inventory  as  an  average  cost 
price  of  $1.03^  so  that  a  sale  of  5,000  bushels  at  $1.30 
would  give  a  realized  profit  of  $1,333.33. 

When  the  merchandise  to  be  inventoried  has  not  been 
purchased  but  has  been  manufactured  the  determination 
of  cost  price  is  much  more  difficult  and  the  general  ques- 
tion of  manufacturing  cost  will  receive  further  considera- 
tion. The  principle  is  clear  enough.  All  the  costs  which 
are  immediately  necessary  to  secure  the  goods  may  be 
included  in  the  inventory  price.  But  difficulties  arise  in 
applying  this  simple  rule,  because  of  the  uncertainty 
whether  certain  payments  such  as  partners'  salaries  should 
be  included  in  cost  of  goods  or  treated  as  part  of  the  gen- 
eral expenses  of  the  business.  Attempts  have  even  been 
made  to  include  a  certain  percentage,  representing  normal 
profits,  in  the  cost  price,  a  procedure  which  not  only 
opposes  accounting  practice  but  which  has  been  prohibited 
by  the  courts.1 

Goods  in  the  process  of  manufacture  for  the  general 
market  should  not  be  inventoried  at  more  than  the  cost 
price;  but  when  they  are  manufactured  on  a  specific  con- 

1  Providence  Rubber  Co.  v.  Goodyear.     9  Wall.  788. 


tract  it  is  correct  to  take  into  account  the  selling  price, 
making  due  allowance  for  the  unfinished  work  still  to  be 
done,  the  risks  intervening  and  interest  charges  involved. 
Where  the  contract  period  extends  beyond  the  current  fiscal 
period  such  inventorying  is  not  only  permissible  but  is  the 
only  correct  method.  Otherwise  the  profits  on  the  contract 
work  would  all  appear  in  the  year  when  goods  are  deliv- 
ered, although  the  labor  involved  belonged  almost  en- 
tirely to  a  preceding  year. 


BIBLIOGRAPHICAL  NOTE  TO   CHAPTER  V 

.NEYMARCK,  A.  Du  meiileur  mode  &  indiquer  AU  point  de  vue 
statistique  international  pour  la  confection  des  bilans  des 
societes  anonymes.  Bulletin  de  VInstitut  international  de 
statistique.  Tome  XIV,  livraison  2,  pp.  143-199.  [Contains 
answers  to  a  series  of  questions  propounded  to  various  mem- 
bers of  the  Institute.] 

PIXLEY,  F.  W.  Auditors,  their  Duties  and  Responsibilities. 
Vol.  I,  Chapter  XI.  Ninth  edition.  London,  1906. 

SIMON,  H.  V.  Die  Bilanzen  der  Aktiengesellschaften,  pp.  326-444. 
3te  Aufl.  Berlin,  1899. 

On  the  Valuation  of  Real  Estate. 
HURD,  R.  M.     Principles  of  City  Land  Values.     New  York,  1903. 

On  the  Valuation  of  Machinery,  etc. 

ARNOLD,  H.  L.  The  Complete  Cost  Keeper,  pp.  353-362.  New 
York,  1900. 

MATHESON,  E.  The  Depreciation  of  Factories,  Mines,  and  Indus- 
trial Undertakings  and  their  Valuation.  Chapter  VI-XIII. 
Second  edition.  London,  1903.  [A  standard  authority.] 

NORRIS,  H.  M.  Machine  Tool  Depreciation  as  an  Element  of 
Manufacturing  Cost.  Engineering  Magazine,  XVI,  p.  957. 
[Discusses  views  of  Smith.] 

SMITH,  O.  Inventory  Valuation  of  Machinery  Plant.  Trans- 
actions American  Society  of  Mechanical  Engineers,  VII,  p.  433. 


106  MODEKN   ACCOUNTING 

On  the  Valuation  of  Investments. 
MAY,  G.  O.     The  Proper  Treatment  of  Premiums  and  Discounts  on 

Bonds.     Journal  of  Accountancy,  II,  p.  174. 
SPRAGUE,  C.  E.    The  Accountancy  of  Investment.    Fourth  edition. 

New  York,  1907.     [A  valuable  treatise  giving  mathematical 

formulas.] 
• Problems  and  Studies  in  the  Accountancy  of  Investment. 

New  York,  1906.     [A  supplement  to  the  above.] 
> Premiums   and   Discounts.     Journal  of  Accountancy,   II, 

p.  294.     [A  criticism  of  the  article  by  May.] 

See  also  the  references  to  Chapters  VII  and  XII. 


CHAPTER    VI 

IMMATERIAL  ASSETS 
GOODWILL 

GOODWILL,  which  may  be  taken  as  the  typical  form  of 
Immaterial  Assets,  represents  the  value  of  business  con- 
nections, the  value  of  the  probability  that  present  custom- 
ers will  continue  to  buy  in  spite  of  the  allurements  of  com- 
peting dealers. 

While  the  inclusion  of  intangible  assets  in  the  inventory 
of  corporations  is  not  infrequently  the  object  of  popular 
criticism  the  legitimacy  of  Goodwill  has  long  been  recog- 
nized both  by  the  .courts  and  by  accountants.  A  clear 
statement  of  the  principle  is  given  in  the  case  of  "Washburn 
v.  National  Wall  Paper  Company,  where  the  court  said: 
"  AVhen  an  individual  or  a  firm  or  a  corporation  has  gone 
on  for  an  unbroken  series  of  years  conducting  a  particular 
business,  and  has  been  so  scrupulous  in  fulfilling  every  obli- 
gation, so  careful  in  maintaining  the  standard  of  the  goods 
dealt  in,  so  absolutely  fair  and  honest  in  all  business  deal- 
ings that  customers  of  the  concern  have  become  convinced 
that  their  experience  in  the  future  will  be  as  satisfactory 
as  it  has  been  in  the  past,  while  such  customers '  good  report 
of  their  own  experience  tends  continually  to  bring  new 
customers  to  the  concern  there  has  been  produced  an  ele- 
ment of  value  quite  as  important— in  some  cases,  perhaps, 
far  more  important — than  the  plant  or  machinery  with 
which  .the  business  is  carried  on.  That  it  is  property  is 
abundantly  settled  by  authority,  and,  indeed,  is  not  dis- 
puted. That  in  some  cases  it  may  be  very  valuable  prop- 

107 


108  MODERN   ACCOUNTING 

erty  is  manifest.  The  individual  who  has  created  it  by 
years  of  hard  work  and  fair  business  dealing  usually  ex- 
periences no  difficulty  in  finding  men  willing  to  pay  him 
for  it  if  he  be  willing  to  sell  it  to  them. ' ' x 

Similarly  accountants  have  recognized  that  the  pur- 
chase of  Goodwill  of  an  established  firm  may  be  a  most 
valuable  transaction,  for  it  may  save,  as  Guthrie  has 
neatly  put  it,  "  the  period  of  perilous  probation."  Indeed 
even  the  Goodwill  of  a  bankrupt  house  is  at  times  legiti- 
mately sold  at  a  high  price,  and  where  so  purchased  it  is 
as  true  an  asset  as  factory,  machine,  or  stock  of  mer- 
chandise. 

But  in  valuing  Goodwill  for  the  inventory  the  limita- 
tion of  its  value  to  its  cost  must  be  most  rigorously  ob- 
served. It  has  been  seen  that  the  restriction  of  inventory 
value  to  cost  price  is  of  rather  general  application,  but  its 
force  is  much  greater  when  the  Goods  to  be  valued  are 
immaterial.  No  one  would  object  to  the  inclusion  in  the 
inventory  of  treasure  trove  even  though  it  cost  the  finder 
nothing.  But  Goodwill  is  rigorously  excluded  unless  it 
has  been  secured  at  a  cost.  Hence  it  is  recognized  as 
legitimate  for  the  purchaser  of  Goodwill  to  include  it 
among  his  assets,  but  accounting  practice  prudently, 
though  perhaps  illogically,  forbids  the  firm  which  created 
the  Goodwill  to  place  in  the  Balance  Sheet  any  value  on 
the  clientele  which  it  has  built  up  and  which  it  could  at 
any  moment  sell  for  a  large  sum. 

This  conservative  restriction  is  doubtless  necessary  to 
prevent  a  harmful  exaggeration.  Human  nature  is  so  in- 
curably optimistic,  especially  when  it  comes  to  estimating 
one's  own  possessions.  The  boy's  jackknife,  the  citizen's 
fatherland,  the  man's  children,  are  in  normal  cases  a  little 
better  than  similar  possessions  of  anyone  else.  The  same 
phenomenon  appears  in  the  valuation  of  one's  business 

»  81  Federal  Rep.  20. 


IMMATEKIAL  ASSETS  109 

assets,  where  the  natural  instinct  to  overvalue  one's  own 
possessions  is  augmented  by  the  fact  that  such  overvalua- 
tion may  be  the  means  of  overreaching  some  one  else  in  a 
business  deal.  In  proportion  as  it  is  difficult  to  verify 
values  it  is  therefore  customary  to  limit  the  value  at  which 
they  are  appraised.  Cash  being  of  definite  value  may  be 
listed  though  it  cost  nothing;  quoted  securities  or  com- 
modities may,  according  to  some  authorities,  be  listed  at 
the  market  value  even  though  that  exceed  the  cost;  but 
Goodwill,  because  of  its  vague  nature  and  the  difficulty  of 
verifying  its  appraisal  is  to  be  excluded  unless  it  has  been 
purchased.1 

But  it  is  not  always  easy  to  determine  whether  there 
has  been  an  actual  -purchase  of  Goodwill,  or  what  price, 
if  any,  has  been  paid.  Most  frequently  where  a  corpora- 
tion buys  out  the  business  of  a  partnership  or  of  another 
corporation  the  purchase  is  made  with  stock,  not  with 
cash.  When,  as  is  generally  the  case,  the  par  value  of  the 
stock  given  is  in  excess  of  the  value  of  the  tangible  assets 
it  is  at  times  difficult  to  determine  whether  the  difference  in 
these  values  represents  Goodwill  purchased  or  a  mere  dis- 
count of  the  stock  issued.  In  ordinary  American  practice 
the  accountants  have  assumed  the  existence  of  Goodwill 
wherever  the  tangible  property  purchased  is  less  than  the 
par  value  of  the  stock  issued  therefor.  Thus  in  the  recent 
capitalization  of  a  large  catalogue  house,  whose  total  assets 
were  less  than  $20,000,000,  there  was  added  at  the  time 
of  reorganization  the  item  of  Goodwill  valued  at  $30,000,- 
000.  The  exaggeration  in  this  figure  is  clearly  established 
by  the  quoted  prices  of  the  stock  issued  for  its  purchase. 

1  For  a  possible  exception  to  this  see  the  decision  in  the  English  case 
In  re  Barrow  Haematite  Steel  Co.  ([1900]  2  Ch.  855)  where  it  was  held 
that  a  decline  in  the  value  of  part  of  the  assets  should  be  offset  by  the 
introduction  of  Goodwill  before  it  could  be  claimed  that  capital  had 
been  impaired. 


110  MODERN   ACCOUNTING 

In  general  the  recent  organization  of  the  so-called  trusts 
included  a  high  valuation  for  Goodwill,  ordinarily  roughly 
corresponding  to  the  amount  of  common  stock  issued.  In 
most  cases  this  was  grossly  overstated,  and  openly  and 
notoriously  incorrect.  This  is  shown  for  instance  by  the 
experience  of  the  Asphalt  Company  whose  earnings  esti- 
mated at  ten  per  cent,  of  the  capitalization  proved  to  be 
less  than  one  per  cent. ;  or  by  that  of  the  American  Malt- 
ing Company  where  the  $2,100,000  earnings  estimated  in 
the  prospectus  dwindled  to  a  negative  quantity  in  the  first 
year  of  operation.  It  is,  therefore,  necessary  to  examine 
the  conditions  in  which  Goodwill  exists,  and  to  consider 
the  principles  governing  its  valuation. 

The  value  of  Goodwill,  or  the  other  similar  categories, 
"  Franchise,"  "Patent  Rights,"  "  Trade  Marks,"  "  Trade 
Names,"  depends  on  the  existence  of  some  legal  right  or 
trade  custom  which  will  bring  to  the  owner  of  the  business 
profits  in  excess  of  that  to  be  obtained  in  other  ordinary 
channels  of  trade.  If  the  firm's  name  and  its  past  repu- 
tation for  good  dealing  will  bring  to  its  doors  a  flow  of 
customers  without  the  expense  of  profuse  advertising  or 
despite  the  lower  prices  of  less  favorably  known  rivals, 
there  is  a  source  of  profits  in  excess  of  what  could  be 
obtained  by  establishing  a  new  house.  If  the  right  to  use- 
a  particular  location  to  the  exclusion  of  others,  whether 
that  location  be  of  a  newspaper  stand  on  a  crowded  cor- 
ner, or  a  street  railway  with  an  exclusive  franchise  to 
the  streets,  there  is  at  least  a  possibility  that  ft  opens  the 
doors  to  the  receipt  of  profits  which  could  not  be  gained  in 
any  line  of  business  not  thus  specially  favored.  If  any 
business  is  protected  by  a  monopoly,  whether  the  legal 
monopoly  of  a  patent  right  or  a  partial  business  monopoly 
resting  on  the  combination  of  all  present  competitors  in 
a  "  trust,"  there  is  a  possibility  of  maintaining  prices  at 
a  level  which  will  yield  profits  in  excess  of  the  current 


IMMATERIAL   ASSETS  111 

normal  rate,  and  hence  a  legitimate  basis  for  the  valuation 
of  Goodwill. 

The  one  justification  of  a  valuation  of  Goodwill  is  the 
existence  of  some  transferable  right  which  will  secure  to 
the  purchaser  profits  in  addition  to  the  normal  returns  on 
the  amount  of  capital  invested  in  the  business.  Such  a 
surplus  over  the  normal  income  to  be  derived  from  invest- 
ment is  practically  an  uncertain  annuity  and '  its  value 
depends  (1)  on  the  annual  amount,  (2)  on  the  degree  to 
which  it  can  be  transferred,  and  (3)  on  the  length  of  time 
during  which  it  will  continue.  The  determination  of  the 
amount  of  excess  profits  is  generally  based  on  the  records 
of  past  experience  and  relies  upon  the  accounts  of  the 
firm  or  corporation  selling  its  Goodwill.  How  long  a 
period  should  be  taken  into  survey  is  a  delicate  problem. 
A  single  year  is  not  a  sufficient  period,  for  the  high  profits 
of  that  year  may  be  altogether  due  to  exceptional  tempo- 
rary conditions.  Nor  should  too  long  a  period  be  consid- 
ered lest  the  conditions  of  the  remoter  years  be  so  dif- 
ferent from  those  prevailing  at  the  time  of  valuation  as 
to  make  an  average  of  little  significance.  Especially  if 
the  business  is  declining,  the  inclusion  of  the  operations 
of  the  earlier  years  in  the  estimate  is  objectionable,  as 
tending  to  exaggerate  the  showing  of  profits.  Yet  in 
recent  capitalizations  the  National  ^all  Paper  Company 
based  the  estimate  of  the  valuation  of  Goodwill  on  the 
earnings  of  only  eleven  months.  The  Rubber  Goods  Manu- 
facturing Company  took  the  earnings  of  a  single  year; 
the  National  Salt  Company  averaged  the  earnings  of  two 
years,  and  the  National  Cordage  Company  those  of  three 
to  five  years.  In  English  corporation  finance  the  latter 
figures  seem  to  be  most  generally  used. 

In  determining  the  amount  of  surplus  profits  to  be  capi- 
talized two  distinct  methods  are  used.  One  is  to  capitalize 
the  entire  net  profits,  of  course  being  sure  that  the  profits 


112  MODEKN   ACCOUNTING 

stated  are  really  net  profits  and  that  due  allowance  has 
been  made  for  depreciation  and  other  charges,  and  from 
this  capitalization  is  deduced  the  value  of  the  tangible 
assets.  This  was  done  by  the  National  Wall  Paper  Com- 
pany. Another  way  is  to  deduct  from  the  net  profits  the 
assumed  normal  rate  of  profits  on  the  capital  actually 
Invested  and  then  capitalize  the  remaining  surplus  earn- 
ings. This  method  is  more  commonly  used  in  floating 
English  companies.  Of  course  the  results  will  be  the  same 
provided  the  rate  at  which  the  earnings  are  capitalized  is 
the  same  as  the  assumed  rate  to  be  derived  from  invested 
capital. 

2.  The  transferability  of  the  excess  income  is  a  point 
which  varies  greatly.    When  a  lawyer,  physician  or  other 
professional  man  sells  his  Goodwill  it  is  always  a  question 
as  to  how  far  the  clientele  which  he  has  had  is  a  purely 
personal  matter.     On  the  other  hand  the  surplus  derived 
from  an  exclusive  franchise  of  a  street  railway  is  clearly 
transferable.     Between  these  two  limits  there  is  room  for 
variation,  depending  largely  on  the  degree  to  which  the 
personal  element  of  the  proprietor  has  been  a  determining 
factor  in  creating  the  profits.    It  is  not  uncommon  where 
Goodwill  is  bought  by  a  corporation  to  specify  that  the 
former  proprietors,  managers  or  officers  shall  agree  to  con- 
tinue their  services  for  a  given  time  after  the  purchase, 
as  was  done,   for  instance,  in  the  case  of  the   Cordage 
Trust. 

3.  The  duration  of  the  annual  excess  depends  on  two 
factors:  those  having  to  do  with  competition,  and  those 
relating  to  general  trade  conditions.    Error  has  been  com- 
mitted in  the  calculations  of  many  of  the  large  combina- 
tions both  in  this  country  and  in  England  in  assuming 
the  continuance  of  large  profits,  where  that  is  conditioned 
on  the  absence  of  competition.    A  notable  instance  was  in 
the  case  of  the  Columbia  Straw  Paper  Company,  where 


IMMATEKIAL   ASSETS  113 

large  profits  were  perhaps  honestly  estimated  on  the  basis 
of  the  high  prices  to  be  obtained  by  a  practical  monopoly. 
But  as  soon  as  prices  were  raised  old  mills  were  reopened, 
new  mills  were  immediately  constructed,  and,  in  addition, 
new  competition  arose  through  the  introduction  of  wood- 
pulp  as  the  basic  material  of  wrapping  paper  such  as  was 
previously  manufactured  exclusively  from  straw.  As  a 
result  the  company  was  insolvent  in  less  than  two  years. 

Almost  equal  error  has  arisen  from  neglecting  the  pos- 
sibility of  change  of  general  trade  conditions.  Thus  in  the 
consolidation  of  English  factories  for  making  bicycles  a 
large  valuation  was  placed  on  the  Goodwill  based  on  the 
continuance  of  previous  demand;  but  almost  immediately 
after  the  shares  of  the  combination  were  floated  the  fad 
for  bicycle  riding  ceased,  and  with  it  the  value  of  the 
shares  so  eagerly  purchased  by  the  public.  Similarly  the 
Goodwill  of  a  distillery,  or  of  a  saloon,  might  cease  be- 
cause of  the  emergence  of  a  sentiment  in  favor  of  absti- 
nence or  the  enactment  of  a  prohibition  law. 

With  all  the  variables  referred  to,  it  is  evidently  impos- 
sible to  lay  down  a  rate  at  which  to  capitalize  Goodwill. 
Dicksee  gives  a  rough  estimate  that  to  determine  the  value 
of  the  Goodwill  of  a  trading  company  the  average  net 
profits— interest  on  capital  and  allowances  for  proprietors' 
services  having  been  deducted — should  be  multiplied  from 
one  to  five  times ;  the  multiplier  to  be  used  for  a  manufac- 
turing concern  being  from  one  to  four,  for  a  professional 
practice  one  to  three,  for  newspapers  and  "  other  quasi- 
monopolies  ' '  $  much  higher  figure,  ten  not  being  unusual 
In  determining  the  value  of  Goodwill  of  the  trusts  already 
referred  to  the  profits  were  multiplied  by  10  for  the 
Cordage  Trust,  by  10  for  the  Salt  Trust,  by  14|  for  the 
Rubber  Goods  Manufacturing  Company,  and  by  16  for 
the  National  Wall  Paper  Company.  But  in  these  cases 
the  element  of  monopoly  was  perhaps  erroneously  sup- 


114  MODERN   ACCOUNTING 

posed  to  exist,  and  the  profits  were  the  total  net  profits, 
not  those  profits  less  the  normal  rate  of  interest  on  in- 
vested capital.  Furthermore  payment  in  these  cases  was 
made  generally  in  stock  worth  far  less  than  its  par  value. 

Mr.  Charles  S.  Fairchild  gives  the  following  descrip- 
tion of  the  method  of  estimating  the  value  of  Goodwill : 

"  In  some  cases  the  value  of  the  Goodwill  acquired 
has  been  very  carefully  estimated.  For  example,  the  pro- 
moters of  one  company  made  a  special  point  of  the  con- 
servative methods  employed  in  arriving  at  the  value  of 
the  Goodwill  of  the  companies  which  were  consolidated. 
According  to  their  statement,  the  new  company  was  vir- 
tually buying  the  real  estate,  plants,  stock,  etc.,  on  the 
basis  of  appraised  cash  value.  In  addition  an  allowance 
was  made  for  Goodwill,  calculated  upon  this  basis;  from 
the  net  profits  of  each  company  deduct  7  per  cent,  upon 
the  capital  actually  employed,  1£  per  cent,  upon  sales, 
which  were  about  three  times  the  capital,  2  per  cent,  for 
depreciation  on  brick  buildings,  4  per  cent,  on  frame 
buildings,  and  8  per  cent,  on  machinery.  If  the  average 
net  earnings  were  in  excess  of  all  this,  and  in  this  case  it 
appeared  from  the  promoter's  statement  that  they  usually 
were,  the  excess  was  capitalized  as  "  Goodwill  "  on  the 
basis  of  20  per  cent,  per  annum— i.  e.,  the  value  of  the 
Goodwill  was  estimated  to  be  five  times  the  amount  of 
such  earnings  in  excess  of  7  per  cent,  on  capital  and  al- 
lowance for  depreciation. ' '  * 

As  has  been  shown  by  Francis  More  it  is  correct  to 
have  a  different  rate  for  capitalizing  different  portions  of 
the  surplus  earnings.  Thus,  to  use  the  illustration  given 
by  him,  if  it  is  assumed  that  8  per  cent,  is  the  normal  rate 
of  profits,  a  concern  having  assets  worth  $100,000  and  earn- 
ing $8,000  affords  no  basis  for  Goodwill, .  the  earnings 

1  Publications  of  the  American  Economic  Association,  3rd  Series,  I. 
p.  156 


IMMATERIAL  ASSETS  115 

snowing  no  excess  over  the  normal  rate.  If  earning  $13,- 
000  the  excess  of  $5,000  might  be  capitalized,  say  at  seven 
years'  purchase  making  a  valuation  of  $35,000.  But  if 
the  earnings  were  $18,000  it  would  be  unwise  again  to  add 
$35,000,  but  the  additional  surplus  of  $5,000,  might  per- 
haps be  multiplied  by  five.  And  so  each  additional  por- 
tion of  surplus  should  be  taken  at  a  lower  rate  of  capital- 
ization, or  to  express  the  idea  more  generally,  the  larger 
surplus  earnings  are  relatively  to  normal  profits,  the  lower 
should  the  rate  of  capitalization  be.  This  is  reasonable 
since  a  small  excess  is  more  likely  to  continue  than  a  large 
one,  affording  a  smaller  field  for  competition,  and  probably 
being  less  subject  to  other  fluctuations. 

"What  has  been  said  in  support  of  the  legitimacy  of 
including  Goodwill  and  similar  immaterial  assets  in  the 
inventory  in  no  way  justifies  the  practice,  all  too  common, 
of  listing  a  nonexistent  or  a  greatly  overvalued  Goodwill. 
Such  an  item  is  not  merely  immaterial  but  also  imaginary. 
From  the  view  point  of  accounting,  there  is  no  more  justi- 
fication for  such  a  procedure  than  there  is  for  placing  in 
the  list  of  assets  a  brick  building  which  has  no  existence, 
or  for  stating  in  the  Balance  Sheet  the  money  in  bank  at 
twice  the  sum  actually  on  deposit.  As  was  said  by  the 
United  States  Supreme  Court,  "  Goodwill  is  a  legitimate 
asset  where  it  is  actually  existent,  but  it  must  not  be  some- 
thing unsubstantial  and  shadowy  but  capable  of  pecuniary 
estimation. ' ' x 

The  question  has  arisen  as  to  whether  Goodwill  having 
once  been  properly  entered  in  the  books  at  its  cost  price 
should  continue  at  that  figure,  or  whether  it  should  be 
subject  to  periodical  revaluation  or  regularly  written  off, 
as  machinery  is  marked  down  to  allow  for  depreciation. 
In  this,  as  in  other  questions  of  accounting  theory,  opinions 
differ.  In  the  discussion  which  has  been  carried  on  among 

>  Camden  v.  Stuart,  144  U.  S.  104  (1892). 


116  MODEKN  ACCOUNTING 

English  accountants,  Child,  Cooper,  Guthrie  and  Pixley 
are  among  those  favoring  a  regular  writing  off  of  Goodwill, 
while  Dieksee,  Caldicott,  Garcke  and  Fells,  and  James 
argue  that  it  may  be  continued  at  its  original  figure  re- 
gardless of  changes  in  its  value.  Some  set  a  less  absolute 
rule  but  differ,  and  somewhat  strangely.  Thus  Welton 
in  general  opposes  the  writing  off  of  Goodwill,  but  says 
that  it  should  be  done  when  the  company  has  not  earned 
the  anticipated  profits  on  which  the  valuation  of  Good- 
will was  based.  But  with  Guthrie  the  writing  down  of 
Goodwill  is  conditioned  on  the  company  having  unusual 
profits  which  can  be  appropriated  for  that  purpose. 

The  English  courts,  have  decided  in  Wilmer  v.  McNa- 
mara  ([1895],  2  Ch.  245)  that  even  where  the  Goodwill 
has  actually  declined  in  value  it  is  not  necessary  to  charge 
the  shrinkage  against  profits.  The  decision  was  based  on 
the  conception  that  Goodwill  is  "  fixed  "  capital,  and  the 
application  of  a  previous  decision  *  that  a  decline  in  the 
value  of  "  Fixed  Capital  "  (or  permanent  assets)  need  not 
be  taken  into  account  in  determining  profits. 

From  one  point  of  view  it  is  true  that  Goodwill  is  the 
most  permanent  of  assets.  Anything  else,  even  the  factory 
site  may  conceivably  be  sold  without  necessarily  terminat- 
ing the  business.  But  Goodwill  cannot  be  disposed  of 
without  selling  the  business  itself.  Furthermore  the  very 
indefiniteness  of  Goodwill  renders  its  overvaluation  less 
harmful  than  that  of  other  assets.  Every  one  knows  that 
the  price  paid  for  Goodwill  gives  no  indication  of  its  pres- 
ent value,  and  that  at  any  time  a  new  valuation  needs  to 
be  taken.  Hence  there  is  little  danger  of  deception  by  con- 
tinuing it  among  the  assets  at  the  cost  price.  But  this 
doctrine  of  the  permanence  of  Goodwill  seems  inconsist- 
ent with  the  theory  of  valuing  it  as  the  purchase  of  a 
temporary,  terminating  annuity.  Strict  logic  requires,  at 

'  See  below,  p.  208. 


IMMATERIAL   ASSETS  117 

least  where  the  price  paid  for  Goodwill  is  definitely  based 
on  a  number  of  years'  purchase  of  excess  earnings,  that 
the  valuation  should  be  written  off  in  the  same  number  of 
years.  To  require  the  writing  off  only  when  the  expected 
returns  are  not  realized  appears  unnecessarily  hard  on  the 
stockholders  for  they  are  doubly  burdened:  first,  by  the 
decline  in  expected  earnings,  and  then  by  a  further  charge 
against  the  diminished  earnings  to  cover  decline  in  Good- 
will. To  mark  down  Goodwill  when  profits  are  unusually 
high  is  clearly  illogical,  though  it  is  not  thereby  necessarily 
discredited  in  accounting  practice,  for  it  reduces  the  valu- 
ation of  excess  earnings  at  the  ve^ry  time  and  in  direct 
ratio  to  the  increase  of  such  earnings.  Probably  the  most 
satisfactory  solution  is  ordinarily  to  write  off  Goodwill  in 
proportion  to  the  number  of  years  figured  in  its  valuation, 
for  in  any  event  it  is  an  uncertain  asset,  and  a  depreciation 
of  even  fixed  assets"  (in  which  class  it  is  somewhat  forced 
to  include  Goodwill),  wrhile  it  legally  need  not  be  made,  is 
justified  on  the  plea  of  conservatism.  And  where  it  is 
clear  that  the  valuation  of  the  Goodwill  was  erroneous, 
that  it  is  not  worth  its  book  value,  the  best  method  of 
adjustment  is  that  advocated  by  Dicksee,  to  offset  the 
decline  in  its  value  by  a  reduction  of  capital,  not  by  a 
charge  against  profits. 

In  American  corporation  finance  Goodwill  frequently 
is  not  openly  shown  on  the  Balance  Sheet.  Oftentimes  it 
is  included  with  the  tangible  property  under  the  title 
' '  Property,  etc., "  or  it  may  be  combined  with  other  items 
of  an  intangible  nature  under  headings  such  as  "  Good- 
will, Patents,  Leases,  Trade  Marks,  etc."  (American  Cot- 
ton Oil  Co.),  "  Patent  Rights  and  Goodwill  "  (American 
Glue  Co.),  "  Franchises,  Goodwill,  etc."  (American 
Graphophone  Co.),  "Goodwill  and  Patents"  (Sears 
Roebuck  Co.).  While  such  property  rights  as  patents, 
trade  marks,  etc.,  are  quite  different  in  their  legal  naturo 


118  MODEKN   ACCOUNTING 

from^  Goodwill  yet  economically  they  are  very  similar, 
both  representing  a  transferable  right  from  which  excep- 
tional profits  may  be  derived.  Those  which  are  distinctly 
terminable,  as  patents,  copyrights,  etc.,  differ  from  Good- 
will in  that  the  value  must  some  day  disappear,  and  hence 
the  necessity  of  marking  down  their  value  is  apparent. 

DEFERRED  ASSETS 

,  Another  class  of  items  appearing  in  the  Balance  Sheet 
are  called  Deferred  Assets  or  Deferred  Charges.  These 
terms  indicate  that  payment  has  been  made  of  expenses 
properly  belonging  to  a  period  subsequent  to  the  date  of 
the  Balance  Sheet.  In  this  class  are  found  such  items  as 
"  Discount  and  Commission  on  Bonds,"  "  Deferred 
Charges  to  Operation,"  "  Cost  of  Stripping  Surface  of 
Mines,"  "  Interest  paid  in  advance  "  and  many  others. 

Attention  has  been  called  to  the  discussion  as  to  whether 
certain  expenditures,  especially  those  made  at  the  begin- 
ning of  a  company's  operations,  should  be  considered  as 
mere  expenses  or  as  part  of  the  cost  of  the  plant  to  be 
charged  to  Construction  account.  The  items  appearing  in 
Deferred  Assets  hold  to  some  extent  an  intermediate  posi- 
tion, for  they  are  not-  conceived  of  as  representing  part  of 
the  cost  of  permanent  assets,  nor  are  they  charged  at  once 
to  the  expenses  of  the  year.  Being  clearly  expenses  they 
are  yet  expenses  which  are  offsets  of  future  earnings,  not 
of  past  receipts.  While  in  many  cases  not  representing 
any  actual  asset,  they  are  correctly  treated  as  though  they 
were  assets.  This  may  be  clearly  illustrated  by  an  item 
representing  ' '  Interest  paid  in  advance. ' '  This  may  be 
an  irrecoverable  expense.  It  may  not  even  be  a  reduction 
of  the  amount  of  debts,  for  in  many  cases  a  prepayment 
of  a  debt  does  not  bring  with  it  a  discount  for  the  time 
before  maturity.  But  to  the  going  concern  it  is  immaterial 


IMMATEEIAL   ASSETS  119 

whether  the  interest  is  paid  in  advance,  or  not  being  paid 
there  is  in  the  treasury  cash  sufficient  to  pay  the  interest 
when  it  matures.  Thus  the  item  "  Interest  paid  in  ad- 
vance "  is  practically  the  same,  so  far  as  meeting  the 
interest  expenses  of  the  next  fiscal  period,  as  an  equivalent 
amount  of  cash.  The  former,  as  well  as  the  latter,  may 
therefore  legitimately  be  treated  as  an  asset.  As  such 
accounts  represent  a  prepayment  or  anticipation  of  an 
expense,  and  provide  for  the  proper  adjustment  of  net 
profits  as  between  different  fiscal  periods  they  are  some- 
times called  Anticipation  accounts,  or  Adjustment  ac- 
counts. The  latter  term  is,  however,  used  somewhat 
ambiguously,  and,  especially  in  England,  signifies  what  is 
also  known  as  a  Collective  account,  or,  in  recent  American 
nomenclature,  a  Controlling  account. 

In  some  cases,  as  where  it  represents  interest  prepaid 
for  a  short  period,  the  Deferred  Asset  must  evidently  be 
treated  as  an  expense  of  the  next  fiscal  period.  In  other 
cases  the  Deferred  Asset  represents  the  prepayment  of  an 
expense  which  pertains  to  the  operations  of  several  years, 
as,  for  instance,  the  cost  of  stripping  the  surface  may 
cover  perhaps  twenty  years  of  mining  operations.  Here 
evidently  it  is  strictly  necessary  that  the  total  amount 
should  be  charged  off  within  the  period  to  which  it  applies. 
In  some  cases  the  Deferred  Assets  really  represent  pay- 
ments covering  permanent  advantages,  as  where  Organ- 
ization Expenses  are  included  under  this  general  head. 
Here  it  is  not  strictly  necessary  that  the  charge  should  be 
written  off  but  it  may  be  carried  indefinitely,  just  as  it 
might  legitimately  have  been  added  to  the  value  of  the 
plant. 

But  conservative  companies  are  apt  to  charge  these 
items  off  more  rapidly  than  strict  necessity  demands.  Thus 
one  company  charges  off  annually  one-sixth  of  the  "  Dis- 
count on  Bonds  ' '  although  the  bonds  run  for  twenty  years. 


120  MODERN   ACCOUNTING 

In  another  case  one-eighth  of  a  similar  discount  on  bonds 
was  written  off  in  the  first  year,  but  in  the  following  year 
the  entire  remainder  disappeared. 

At  times  there  appear  among  the  assets  items  which 
represent  not  anticipated  expenses  but  unusual  losses 
which  the  corporation  does  not  see  fit  to  charge  at  once 
to  Profit  and  Loss,  nor  to  make  manifest  in  a  reduction  of 
capital.  In  such  cases  the  charges  which  are  deferred  are 
not  the  costs  of  future  earnings,  but  losses  which  it  is 
expected  future  profits  will  cover.  A  striking  instance  of 
such  an  item  is  found  in  the  Balance  Sheet  of  the  United 
Railways  Investment  Company  for  December  31,  1906, 
where  there  appears  "  Earthquake,  Fire,  and  Strike, 
$859,983."  Openly  to  show  such  an  item  is  a  vast  im- 
provement over  carrying  it  concealed  among  the  charges 
to  plant  and  other  material  assets.  Of  course,  it  is  in  no 
sense  an  asset,  properly  speaking  not  even  a  Deferred 
Asset.  But  by  treating  it  as  shown  above  the  loss  does  not 
necessarily  interfere  with  current  profits.  The  legitimacy 
of  so  doing  is  discussed  at  length  in  Chapter  XII. 


BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  VI 

DAWSON,  S.  S.     Goodwill.     Article  in  Encyclopaedia  of  Accounting, 

III,  p.  196. 
DICKSEE,  L.  R.     Goodwill  and  Its  Treatment  in  Accounts.     Third 

edition.     London,   1906.     [The  most  complete  treatment  of 

the  subject.] 

GUTHRIE,  E.     Goodwill.     Accountant,  XXIV,  p.  425. 
MORE,  F.     Goodwill.    Ibid.,  XVII,  p.  282. 


CHAPTER   VII 

DEPRECIATION 

DESTRUCTION  is  the  law  of  nature.  Fixed  capital, 
using  the  term  here  in  its  economic  rather  than  in  its 
accounting  sense,  despite  its  name,  is  not  exempt  from  this 
law.  Even  so-called  permanent  improvements,  such  as 
buildings,  are  all  subject  to  the  ravages  of  time,  which 
Marshall  aptly  defines  as  "  the  complex  of  destructive 
agencies."  All  machinery  is  on  an  irresistible  march  to 
the  junk  heap,  and  its  progress,  while  it  may  be  delayed, 
cannot  be  prevented  by  repairs. 

This  obvious  economic  fact  is  of  momentous  import  to 
accounting,  although  full  recognition  has  not  been  given 
to  it  in  general  practice.  It  is  one  phase  of  the  question 
of  the  inventory  discussed  in  the  preceding  chapters.  It 
implies  that,  in  valuing  all  fixed  assets,  account  must  be 
taken  of  the  lapse  of  time,  and  even  in  the  case  of  ma- 
chinery giving  no  evidence  either  of  use  or  misuse,  the 
bare  fact  that  it  is  a  year  nearer  its  inevitable  goal  is  an 
item  of  which  technical  account  must  be  taken. 

In  estimating  the  cost  of  production  there  must  be  con- 
sidered not  merely  wages  and  material,  interest  and  rent, 
repairs  and  renewals,  but  in  addition  some  allowance  must 
be  made  for  the  diminished  value  of  the  fixed  assets  due 
to  gradual  loss  of  serviceability.  Consequently  profits  are 
not  determined  until  after  allowance  has  been  made  for 
depreciation.  Depreciation  is  not  a'  disposition  of  part  of 
the  profits,  but  an  expense  without  which  profits  can  never 
be  learned.  The  principle  is  clear.  Materials  consumed 

121 


122  MODERN   ACCOUNTING 

in  manufacturing  a  commodity,  as  for  instance  fuel  or  oil, 
are,  of  course,  an  element  of  expense.  This  is  so  because 
an  item  of  wealth  disappears  and  its  effect  can  only  be  to 
diminish  pro  tanto  the  expression  indicating  the  net  wealth. 
Its  loss  is  in  other  words  an  expense.  In  the  case  of  fuel 
the  loss  is  immediate,  and  is,  therefore,  charged  at  once  to 
expense.  Exactly  similar  is  it  with  the  productive  instru- 
ments whose  use  extends  over  a  longer  period.  The  article 
consumed  in  a  single  use  must  be  considered  an  expense 
of  the  current  production,  the  temporary  structure  or  the 
tools  lasting  only  a  year  are  a  charge  against  the  produc- 
tion occurring  during  that  year.  The  more  permanent 
form  of  assets  serving  for  productive  use  during  a  period 
of  years  should  be  spread  as  an  expense  during  the  period 
of  use,  whether  that  be  five  or  fifty  years. 

If,  instead  of  considering  the  year  as  the  fiscal  unit 
of  time,  the  entire  economic  period  of  production  is  re- 
garded as  the  unit,  the  purchase  of  a  machine,  or  the  pur- 
chase of  a  patent  right  are  both  expenses — expenses  to 
the  full  amount  of  the  cost.  If  a  manufacturer,  renting 
his  plant,  produces  a  thousand  engines  in  a  year,  it  is  clear 
that  the  annual  rental  is  a  part  of  the  expense  of  producing 
the  thousand  engines.  But,  if  the  fiscal  period  is  extended, 
it  is  equally  correct  to  say  that  the  production  of  ten  thou- 
sand engines  includes  the  total  payment  of  rent  for  ten 
years.  Exactly  similar  is  it  with  machinery  and  patent 
rights.  Assuming  the  life  of  each  to  be  ten  years,  the 
expense  of  producing  ten  thousand  engines  includes  not 
only  rental  for  ten  years,  but  as  well  the  total  cost  of  the 
machinery  used  and  the  cost  of  the  patent  rights.  A  purely 
artificial  division  of  the  productive  process  into  fiscal  years 
is  made.  It  is,  therefore,  necessary  to  make  an  artificial 
and  at  best  merely  approximate  division  of  these  total 
expenses  into  the  shares  to  be  allotted  to  the  operations  of 
the  several  years. 


DEPRECIATION  123 

"Where  rent,  interest,  or  other  time  payments  are  made 
in  advance,  it  ig  customary,  when  any  such  sum  is  outstand- 
ing at  the  time  the  annual  balance  is  taken,  to  show  the 
prepaid  rent,  interest,  or  insurance  as  an  asset.  Thus  on 
December  1  a  company  may  have  paid  $300  being  six 
months'  interest  in  advance  on  $10,000,  $1,500  as  a  quar- 
ter's rental  in  advance  and  $1,200  one  year's  insurance. 
A  Balance  Sheet  made  December  31  would  show  among 
the  assets :  Interest  prepaid  $250 ;  Rent  in  advance  $1,000, 
Unexpired  insurance  $1,100,  making  the  apportionment,  as 
is  customary  in  the  case  of  short  time  items,  proportionate 
to  the  time  elapsed.  Such  items  are  sometimes  called 
"  Anticipation  "  or  "  Adjustment  "  accounts  and  are  in- 
cluded among  the  Deferred  Assets.  But  logically  the  line 
of  demarcation  from  depreciation  is  extremely  vague. 
Considering  the  entire  productive  process,  the  total  cost  of 
machinery  and  patent  rights,  is,  as  already  stated,  simply 
an  expense  of  production.  But  at  the  end  of  each  year 
part  of  this  expense  is  conceived  as  pertaining  to  future, 
not  to  past  operations,  and  therefore  a  portion  of  the  cost 
of  these  so-called  permanent,  but  really  temporary  assets, 
is  treated  just  as  prepaid  rent,  interest,  and  insurance. 
In  other  words,  the  asset  item  representing  the  value  of 
the  destructible  or  otherwise  terminable  instruments  of 
production  is  logically  similar  to  any  of  the  Anticipation 
or  Adjustment  accounts  which  also  appear  among  the 
assets. 

The  immediate  effect  of  allowing  for  depreciation  is 
properly  to  equalize  profits  during  different  years.  Other- 
wise the  total  cost  of  the  machine  must  appear  as  an  ex- 
pense of  the  year  when  it  finally  proves  unserviceable.  At 
that  time,  its  value  ceasing,  it  can  no  longer  appear  in  the 
inventory.  The  amount  of  Goods  on  hand  being  thus 
diminished,  there  must  needs  be  a  subtraction  from  the 
Profit  and  Loss,  or  other  Proprietorship  account.  But  if 


124  MODERN   ACCOUNTING 

the  original  value  of  the  discarded  machine,  say  $20,000, 
was  continued  on  the  books  throughout  its  entire  life  of 
20  years  it  may  roughly  be  said  that  the  proprietors  in  the 
last  year  showed  an  excessive  loss  of  $19,000,  while  the 
proprietors  during  the  preceding  19  years  overestimated 
their  profits  by  the  same  amount.  Such  a  procedure  is 
improvident  where  there  is  no  change  in  proprietors  or 
stockholders;  it  is  inequitable  where  the  personnel  has 
changed;  in  all  cases  it  is  dangerous  to  the  creditors  who, 
up  to  the  last  year,  have  not  been  shown  the  true  condi- 
tion of  the  company's  assets. 

The  early  writers  on  accounting  made  no  allowance  for 
depreciation,  and  the  advance  that  has  been  made  in  ac- 
counting theory  is  still  somewhat  ahead  of  legal  practice. 
This  is  particularly  true  in  the  United  States.  Germany, 
France,  Belgium,  Switzerland,  Austria  all  prescribe  in 
their  statutes  that  depreciation  must  be  reckoned  before 
showing  profits.  In  England,  as  in  the  United  States,  there 
is  no  such  regulation  of  accounting  practice  as  is  found  on 
the  Continent,  but  the  decisions  of  the  English  courts  are 
perhaps  more  satisfactory  and  consistent  than  those  of  this 
country. 

At  least  so  far  as  material  wear  and  tear  is  concerned 
the  early  case  of  Davison  v.  Gillies  (16  Ch.  Div.  347n 
(1879))  and  the  later  one  of  Bond  v.  Barrow  Haematite 
Steel  Co.,  Lim.  ([1902]  1  Ch.  353)  give  clear  expression 
to  the  doctrine  that  depreciation  must  be  reckoned.  Less 
satisfactory  is  the  position  of  the  American  courts.  In 
the  interesting  case  of  Mackintosh  v.  Flint  &  Pere  Mar- 
quette  Railroad  Company,  the  court  disallowed  certain 
items  charged  against  operating  expenses  for  depreciation 
of  steamers  and  dining  halls,  saying:  "  No  expenditure 
having  actually  been  made  to  meet  such  depreciation  the 
estimated  amount  thereof  could  not  properly  be  deducted 
from  earnings  or  net  income/'  (34  Fed.  Rep.  609.) 


DEPRECIATION  125 

Unfortunately  the  appeal  of  this  case  was  never  brought 
to  trial  as  a  settlement  was  made  between  the  litigants  out- 
side of  court.  But,  in  the  earlier  case  of  United  States  v. 
Kansas  Pacific  Railway  Company,  the  Supreme  Court  of 
the  United  States  held  in  regard  to  a  charge  for  deprecia- 
tion : ' '  We  are  clearly  of  the  opinion  that  it  is  not  a  proper 
charge.  Only  such  expenditures  as  are  actually  made  can 
with  any  propriety  be  claimed  as  a  deduction  from  earn- 
ings." (99  U.  S.  459.) 

In  the  State  courts  there  is  a  variety  of  decisions.  One 
of  the  most  satisfactory  is  a  New  Jersey  case  (Whittaker  v. 
Amwell  Nat.  Bank.  52  N.  J.  Eq.  400  (1894))  where  the 
court  held  that  in  addition  to  the  cost  of  repairs  there  must 
be  "  a  reasonable  allowance  for  depreciation  for  wear  and 
tear  or  constant  use.  ...  It  cannot  be  successfully  con- 
tended that  all  such  machinery  is  not  subject  to  deprecia- 
tion." In  Michigan,  too,  the  propriety  of  allowing  for 
depreciation  seems  to  be  recognized  in  the  case  of  Richard- 
son v.  Buhl  (77  Mich.  632)  and  it  is  most  clearly  allowed 
in  the  Superior  Court  of  New  York  City  in  Conville  v. 
Shook  (24  N.  Y.  Supp.  547  (1893)). 

But  on  the  other  hand  it  has  been  held  in  Georgia  and 
California  that  Depreciation  need  not  be  allowed.  The 
decisions  in  the  latter  State  are  particularly  interesting 
and  refer  to  the  depreciation  of  the  plants  of  water  com- 
panies. To  charge  such  depreciation  against  income  was 
said  by  one  of  the  judges  to  be  "  all  wrong  "  and  "  not  to 
be  tolerated  for  a  moment. ' ' J 

A  recent  most  important  advance  in  the  legal  recogni- 
tion of  depreciation  is  found  in  the  rules  for  preparing 
railroad  accounts  promulgated  by  the  Interstate  Commerce 
Commission.  Here  for  the  first  time  it  is  definitely  pre- 

1  See  Tutt  v.  Land,  50  Geo.  339  (1873);  Emery  v.  Wilson,  79  N.  Y. 
78  (1879);  San  Diego  Water  Co.  v.  San  Diego,  118  Cal  556  (1897); 
Redlands  Water  Co.  v.  Redlands,  121  Cal.  312  (1898). 


126 


MODERN   ACCOUNTING 


scribed  that  a  regular  allowance,  estimated  monthly,  must 
be  made  for  depreciation  of  seven  named  classes  of  equip- 
ment. This  ruling  will  doubtless  have  considerable  effect 
in  giving  recognition  to  the  correctness  of  the  principle 
that  depreciation  is  an  unavoidable  expense. 

Two  methods  are  used  for  booking  depreciation.  For 
instance  in  a  company  whose  Balance  Sheet,  before  taking 
account  of  depreciation  is: 


Dr. 


FORM  37. 
Balance  Sheet. 


Cr. 


Plant $100,000 

Cash 10,000 

$110,000 


Capital $100,000 

Profit  and  Loss 10,000 

$110,000 


an  allowance  of  $2,500  for  depreciation  can  be  shown 
either  by  crediting  that  amount  to  the  Plant  account,  re- 
ducing it  to  $97,500  or  by  crediting  it  to  a  separate  account 
called  Depreciation  Account,  or  some  similar  title,  in  either 
case  the  corresponding  debit  being  to  Profit  and  Loss.  In 
the  latter  case  the  Balance  Sheet  should  be  in  the  form 
below : 


Dr. 


FORM  38. 
Balance  Sheet. 


Cr. 


Plant  at  cost $100,000 

Less  deprecia- 
tion          2,500 


-  $97,500 
Cash 10,000 

$107,500 


Capital 

Profit  and  Loss. 


$100,000 
7,500 


$107,500 


It  is  much  more  satisfactory  thus  to  exhibit  the  original 
cost  of  the  plant  and  not  merely  to  show  the  present  depre- 


DEPRECIATION  127 

elated  value.  Two  companies  might  each  show  a  plant 
valued  at  $50,000.  It  is  not  a  matter  of  indifference  that 
in  one  case  this  represents  the  total  original  cost  of  the 
plant,  while  in  the  other  it  gives  the  residual  value  of  what 
was  once  worth  $100,000.  It  has  often  been  claimed  that 
to  credit  the  depreciation  to  a  separate  account,  instead  of 
to  the  account  showing  the  asset,  may  lead  to  deception. 
This  is  rendered  more  likely  because  the  terms  used  to  in- 
dicate depreciation  are  frequently  ill  defined,  and  there 
is  danger  that  a  mere  recognition  of  depreciation  may  be 
misunderstood  as  indicating  a  reserve  of  profits.  Indeed 
this  fear  of  deception  is  so  strong  that  German  law,  at 
least  according  to  the  interpretation  of  Rehm,  makes  it 
illegal  to  book  depreciation  by  crediting  a  separate  account 
and  requires  that  it  be  shown  by  writing  down  the  value 
of  the  asset.  But  any  danger  from  this  score  is  fully  obvi- 
ated by  showing  the  credit  to  "  Depreciation  Account," 
not  on  the  credit  side  of  the  Balance  Sheet,  but  as  a  sub- 
traction in  an  inner  column  of  the  debit  side,  as  indicated 
above.  Some  writers  furthermore  claim  that  by  carefully 
using  the  title  Depreciation  Account,  and  not  the  com- 
monly used  term  Depreciation  Fund,  all  confusion  between 
depreciation  and  a  reserve  fund  proper  will  be  obviated. 
The  Interstate  Commerce  Commission  directs  that  the 
credit  be  made  to  accounts  entitled  "Accrued  Depreciation — 
Road,"  "Accrued  Depreciation — Equipment,"  "Accrued 
Depreciation — Miscellaneous  Physical  Property, "  a  separate 
account  being  thus  established  for  each  class  of  depreciating 
property. 

Admitting  the  necessity  of  allowing  for  depreciation, 
the  question  arises  as  to  the  basis  on  which  it  is  to  be 
estimated.  It  is  not  possible  to  determine  by  inspection 
the  present  value  of  a  machine  or  plant.  Appraisers  may 
make  the  attempt,  but  in  doing  so  one  element  which  they 
consider  is  the  age  of  the  machine  and  the  depreciation 


128  MODERN   ACCOUNTING 

which  time  itself  has  wrought  in  its  value.  Some  basis 
must  be  adopted  which,  even  if  not  strictly  accurate,  can 
be  conveniently  applied.  So  far  as  depreciation  by  wear 
and  tear  is  concerned  three  factors  are  to  be  considered: 
original  cost,  tenure  of  use,  and  residual  value.  The  last- 
named  is  of  importance,  for  a  machine  is  often  displaced 
before  it  becomes  entirely  worthless.  Its  residual  value  as 
junk  is  exceeded  by  its  value  as  a  second-hand  machine, 
for  the  progressive  establishment  often  discards  machinery 
still  capable  of  considerable  use. 

"With  these  factors  it  is  clear  that  the  problem  is  how 
to  divide  the  difference  between  the  initial  value  and  the 
residual  value  among  the  years  intervening  between  the 
purchase  and  the  discarding  of  the  asset.  Various  systems 
are  in  actual  use,  among  which  the  most  prominent  are 
given  below. 

The  simplest  method  is  to  divide  the  total  depreciation 
by  the  number  of  years'  use,  and  charge  the  quotient  as 
annual  depreciation,  or  in  other  words  to  charge  each  year 
a  fixed  per  cent,  of  the  original  cost.  Thus  a  machine  cost- 
ing $600,  expected  to  last  five  years,  at  which  time  it  will 
have  a  residual  value  of  $100,  should  each  year  have  a 
charge  of  $100  or  16|  per  cent,  of  its  cost  to  depreciation. 
Expressed  algebraically, 

V-V 

D=     Vl  Vz 


in  which  D  represents  the  amount  of  annual  depreciation, 
V1  equals  the  cost  price,  V2  the  residual  value,  and  n  the 
number  of  years. 

The  advantage  of  this  method  is  the  extreme  simplicity 
and  the  ease  with  which  it  can  be  estimated.  For  short- 
lived assets  it  is  doubtless  to  be  preferred.  Objection  is 
sometimes  made  that  it  requires  constant  reference  to  the 
original  cost  price.  If  depreciation  is  directly  subtracted 


129 


from  the  book  value  of  the  asset  by  crediting  the  amount 
to  the  ledger  account  in  which  the  asset  appears,  this  defect 
is  of  some  significance,  necessitating  repeated  reference  to 
a  value  no  longer  exhibited  by  the  accounts.  But  where 
a  separate  depreciation  account  is  established  and  the 
original  cost  remains  an  integral  part  of  the  accounts,  the 
criticism  fails. 

A  second  method  is  to  charge  a  fixed  percentage  of  the 
decreasing  net  value.  This  gives  not  a  constant,  but  a 
diminishing  annual  charge  for  depreciation.  In  the  in- 
stance given  above  the  depreciation  instead  of  being  16§ 
per  cent,  of  the  original  cost,  would  be  30.12  per  cent,  of 
the  diminishing  net  value.  The  annual  charges  would, 
therefore,  be  as  follows: 

FORM  39. 


YEAR 

Value  at  beginning 
of  year. 

Depreciation  at 
30.12%  of  diminishing 
value. 

1      

$600  00 

$180.72 

2                

419  28 

126  28 

3                

293  00 

88  25 

4               

204  75 

61  67 

5          

143  08 

43  09 

Residual  value.   .       

99  99 

Expressed  algebraically  the  formula  is: 

V,  (1-r)   (1-r)   (1-r)   (1-r)   (1-r)  =  V2 

in  which  r  represents  the  percentage  of  the  diminishing 
value  to  be  annually  deducted  for  depreciation,  and  Vt 
and  V2  represent,  as  before,  the  initial  and  the  residual 
value  of  the  asset.  Hence  is  derived  as  a  working  formula : 


which  is  easily  solved  by  the  use  of  logarithmic  tables.    It 
should  be  noted  that  this  formula  cannot  strictly  be  ap- 


130  MODERN  ACCOUNTING 

plied  where  the  asset  has  no  residual  value,  that  is  where 
V2  —  0,  as  for  instance,  in  a  terminable  leasehold,  or  an 
expiring  patent  right.  Practically  it  is  applied  even  in 
such  cases  by  assuming  a  nominal  sum,  say  one  dollar, 
or  one  cent,  as  the  residual  value.  It  will  further  be  noted 
that  because  of  the  elimination  of  fractions  the  balance 
worked  out  generally  will  not  exactly  correspond  with  the 
assumed  residual  value  of  the  asset,  but  as,  at  best,  depre- 
ciation is  a  matter  of  estimate  such  small  divergencies  are 
of  no  significance. 

The  advantage  of  this  method,  in  addition  to  its  easy 
application  to  accounts  showing  the  depreciated  value  of 
the  asset,  is  that  it  makes  the  charge  for  depreciation  less 
with  each  additional  year.  The  argument  in  favor  of  this 
course  is  that  in  the  earlier  years  the  charges  for  repairs 
will  be  slight,  but  these  will  increase  as  the  machine  be- 
comes older.  As  both  repairs  and  depreciation  are  a 
charge  to  expenses  of  production,  the  increasing  repairs, 
and  the  decreasing  depreciation  make  a  uniform  charge  to 
expense,  and  thus  profits  are  more  equally  apportioned  be- 
tween the  several  years  during  which  the  machinery  is 
used.  Furthermore  a  declining  depreciation  is  thought  to 
correspond  better  with  the  economic  facts.  The  difference 
in  value  between  a  new  machine  and  one  that  is  one  year 
old  is  probably  much  greater  than  the  difference  in  value 
of  a  machine  which  has  been  used  19  years  and  the  same 
machine  a  year  later.  Thus  Tiffany  estimates  that  machin- 
ery in  a  flour  mill  depreciates  12^  per  cent,  of  its  cost  the 
first  year,  8  in  the  second,  5  in  the  third,  2£  in  the  fourth, 
and  only  2  per  cent,  each  year  thereafter.  This  decreasing 
rate  of  depreciation  is  preserved  by  figuring  depreciation 
as  a  percentage  of  the  diminishing  value.  The  objections 
to  this  method  are  obvious.  It  involves  a  complicated 
mathematical  calculation,  and  the  annual  rate  of  depre- 
ciation gives  little  indication  to  the  ordinary  man  of  the 


DEPRECIATION 


131 


period  required  to  write  off  the  asset.  Furthermore  it 
increases  the  depreciation  charge  in  the  earlier  years,  and 
in  the  case  of  a  new  concern  this  may  be  distasteful  as 
being  an  additional  charge  against  profits  at  a  time  when 
business  has  not  come  into  full  swing  and  profits  are  low. 
A  third  method,  known  as  the  Annuity  Method,  is  even 
more  complicated.  It  rests  upon  the  assumption"  that  the 
cost  of  production  includes  not  only  repairs  and  the  depre- 
ciation of  machinery,  but  as  well  interest  on  the  amount 
of  capital  invested  in  the  machine.  Depreciation  on  this 
theory  should  be  a  sum  figured  as  a  constant  annual  charge 
sufficient  not  only  to  write  off  the  decline  in  value,  but  also 
to  write  off  annual  interest  charges  on  its  diminishing 
value.  Assuming  the  rate  of  interest  to  be  six  per  cent,  the 
reckoning  should  show: 


Dr. 


FORM  40. 
Machinery  Account. 


Cr. 


Cost  price $600 .00 

Interest  at  6% 36.00 

$636.00 


Balance $511.30 

Interest 30.68 

$541.98 


Balance $417.28 

Interest 25.04 

$442.32 


Balance $317.62 

Interest 19.06 

$436.68 


Balance $211.98 

Interest 12.72 

$224 . 70 


Balance $100.00 


Depreciation $124 . 70 

Balance...         .  511.30 


$636.00 

Depreciation $124 . 70 

Balance 417.28 


$541.98 

Depreciation $124 . 70 

Balance..    317.62 


$442.32 

Depreciation. . , $124 . 70 

Balance 211.98 


$436.68 

Depreciation $124 . 70 

Balance 100.00 

$224.70 


132  MODERN   ACCOUNTING 

Algebraically  the  formula  is  derived  as  follows: 
Vx  R-D )  R-D )  R-D )  R-D )  R-D  =  V2 

in  which  R  equals  1  -f-  (the  rate  of  interest),  or  in  this  case 
1.06  and  D  the  annual  charge  for  depreciation. 

Hence 

V1R5-D(R*+R3+R2+R-j-l)=r  V2 

or  in  simpler  form: 

R5  — 1 

—  V  T?5 V 

—      V  i  J.V  Vo 

R-l 

and 

R5  — 1 

D  =  V1W-  V2-f- 

R-l 

or  generally: 

Rn  -  1 


D  =  (VxR"  -  V2)  * 


R  -  1 


These  values  are  obtained  easily  by  the  use  of  logarithms, 
or  still  more  simply  by  the  use  of  actuarial  tables  prepared 
for  the  use  of  insurance  companies;  for  evidently  V^Rn  is 
the  accumulated  value  of  Fx  at  6  per  cent,  compound  in- 
terest for  n  years,  and  the  coefficient  of  D  is  the  accumu- 
lated value  at  6  per  cent,  interest  of  an  annuity  of  one 
dollar  paid  at  the  end  of  each  of  n  years.  Such  values 
are  given  in  ordinary  actuarial  tables. 

The  use  of  this  system  implies  that  at  the  time  interest 
is  charged  to  the  plant  there  is  a  corresponding  credit 
to  interest  acctrant.  Consequently  the  net  result  to  Profit 
and  Loss  account  taken  as  a  whole  is  that  there  is  an  equal 
annual  charge  of  depreciation,  and  a  diminishing  annual 
credit  for  interest. 

An  objection  to  the  last-named  method  is  that  it  intro- 
duces the  custom  of  marking  up  the  value  of  assets  by  an 
allowance  for  assumed  interest.  In  this  particular  case 


DEPKECIATION 


133 


no  inflation  of  profits  results  because  there  is  an  increased 
charge  against  profits  for  depreciation.  But  it  is  ques- 
tionable whether  it  is  not  so  dangerous  a  practice  as  to 
make  objectionable  anything  which  seems  to  justify  it. 
Furthermore,  unless  interest  is  charged  on  all  capital  in- 
vested, not  merely  on  that  subject  to  depreciation,  there  is 
a  logical  inconsistency  in  reckoning  it  in  depreciation. 
And  finally,  its  value  consists  in  separating  the  profits  of 
manufacturing,  or  other  business  operations,  in  which  de- 
preciating capital  assets  are  used,  from  the  profits  derived 
from  the  use  of  capital.  This  is  so  because  the  large  depre- 
ciation charge  goes  into  the  Trading  account,1  while  the 
countervailing  credit  to  interest  goes  into  the  Profit  and 
Loss  account  proper. 

The  three  methods  of  figuring  depreciation  have  this 
marked  difference.  The  annual  charge  against  profits  de- 
creases where  depreciation  is  a  fixed  percentage  of  the 
diminishing  value  of  the  asset.  It  is  constant  where  depre- 
ciation is  a  fixed  percentage  of  the  cost ;  it  increases  where 
the  third  method  is  used.  A  comparison  of  the  amount 
annually  charged  to  depreciation  under  each  of  the  meth- 
ods described  is  shown  by  the  following  table. 

FORM  41. 

Depreciation  of  Asset  Costing  $600  with  Estimated  Residual  Value  at 
End  of  Five  Years,  of  $100. 


YEAR 

16%%  on 
cost 

30.  12%  on 
diminishing 
value 

Annuity  system,  6£  interest. 

Gross  Charge 

Gross,  less  interest 

1  

$100 
100 
100 
100 
100 

$180.72 
126.28 
88.25 
61.67 
43.08 

$124.70 
124.70 
124.70 
124.70 
124  .  70 

$88.70 
94.02 
99.66 
105.64 
111.98 

2  

3  

4  

5  

Total  

$500 

$500.00 

$623.50 

$500.00 

1  See  Chapter  XV. 


134  MODERN   ACCOUNTING 

Authorities  differ  as  to  the  desirability  of  one  or  other 
of  the  three  methods.  Dicksee's  high  authority  favors  the 
first  for  short-lived  assets,  the  second  for  machinery  in 
general,  the  third  for  long-time  terminable  leaseholds  and 
similar  assets.  Where  the  courts  prescribe  depreciation 
they  have  generally  allowed  the  basis  and,  indeed,  the 
period  to  be  left  to  the  discretion  of  the  company  authori- 
ties. Even  in  Germany  where  statute  law  is  most  precise, 
demanding  that  depreciation  be  reckoned,  and  in  cer- 
tain cases  even  prescribing  the  period,  there  is  no  legal 
preference  given  to  one  or  other  of  the  methods  of  cal- 
culation. Practice,  however,  in  England,  Germany,  and 
the  United  States  seems  to  favor,  in  general,  the  taking  of 
the  diminishing  value  of  the  assets  as  the  basis  of  calcula- 
tion. But  the  Interstate  Commerce  Commission  definitely 
prescribes  that  when  depreciation  is  reckoned  there  shall  be 
a  uniform  monthly  charge,  based  on  the  percentage  of  the 
original  cost  which,  in  accordance  with  the  best  sources  of  in- 
formation, equitably  represents  the  average  current  loss 
from  depreciation. 

In  discussing  the  relative  merits  of  the  differing  sys- 
tems of  depreciation,  it  must  be  borne  in  mind  that  allow- 
ance for  depreciation  is  only  part  of  a  broader  scheme 
whose  purpose  is  to  equalize  charges  between  different 
years.  It  has  been  shown  that  the  real  cost  of  manufac- 
turing includes  both  repairs  and  depreciation  of  plant. 
The  total  amount  paid  on  both  these  accounts  is  properly 
a  charge  to  the  total  cost  of  production  during  the  period 
that  the  plant  lasts.  But  the  accidental  fact  that  actual 
payments  are  not  made  uniformly  is  no  reason  why  the 
annual  charge  should  vary.  One  does  not  consider  the 
semi-annual  installment  of  rent  or  interest  as  an  expense 
peculiar  to  the  month  in  which  it  is  paid.  Neither 
should  the  fact,  if  it  be  one,  that  a  machine  declines  in 
value  more  in  the  first  year  than  in  the  last  year  of  its  life 


DEPRECIATION  135 

justify  making  a  greater  charge  to  costs  in  the  former  year. 
The  complete  and  scientifically  correct  method  of  figuring 
depreciation  compels  that  there  should  be  at  the  same 
time  a  recognition  of  the  necessity  of  repairs  and  a  simul- 
taneous apportioning  of  both  repairs  and  depreciation 
between  the  years  irrespective  of  the  time  when  the  ex- 
pense is  actually  incurred.  There  should,  therefore,  be 
two  estimates  made,  one  of  the  total  shrinkage  of  value 
during  the  life  of  the  machine,  the  other  of  the  total  cost 
of  repairs  during  the  same  period.  This  being  done  there 
should  be  an  equal  apportionment  of  the  sum  of  these  two 
between  the  several  years.  In  other  words  there  should 
be  an  equal  annual  charge  to  expense  and  a  credit  to  De- 
preciation account  and  to  Renewal  or  Repairs  Account. 
Replacement  of  outworn  machines  or  repairs  made  can 
then  be  charged  to  these  accounts.  If  the  estimates  are 
made  with  approximate  accuracy  there  will  result  a  dis- 
tribution of  expense  between  the  several  fiscal  periods. 
But  where  no  such  uniform  annual  charge  is  made  to 
cover  repairs,  and  where  expense  is  annually  charged  with 
the  repairs  actually  made,  sometimes  more  and  sometimes 
less,  a  more  correct  final  showing  will  be  secured  by  mak- 
ing a  sliding  charge  to  depreciation,  as  is  done  where  it  is 
based  on  a  fixed  percentage  of  the  diminishing  value. 
This  does  not  mean  that  the  allocation  of  depreciation  in 
this  manner  is  in  itself  more  correct,  but  that  this  error 
in  apportionment  offsets  and  neutralizes  the  increasing 
charges  for  repairs.  But  this  is  at  best  a  rather  awkward 
rule  of  thumb.  The  fuller,  more  scientific  treatment  of 
both  repairs  and  depreciation,  as  being  properly  a  uniform 
annual  charge,  is  coming  more  into  favor,  and  is  implied 
in  the  scheme  of  accounts  promulgated  by  the  Interstate 
Commerce  Commission. 

Whatever  uncertainty  there  may  be  as  to  the  three  meth- 
ods of  depreciation  already  described,  there  is  no  doubt  a.s 


136  MODERN   ACCOUNTING 

to  the  illegitimacy  of  a  fourth  system  that  is  not  infrequent- 
ly used.  This  is  to  make  the  amount  annually  written  off 
for  depreciation  somewhat  loosely  proportionate  to  profits. 
The  natural  inference  from  this  practice  is  that  in  the  ab- 
sence of  profits  no  depreciation  is  to  be  reckoned;  while 
the  fundamental  principle  involved  is  that  depreciation  is 
something  inexorable,  inevitable,  an  expense  to  be  esti- 
mated before  it  is  possible  to  determine  profits.  This  view 
is  accepted  not  only  by  accountants  but  in  Germany  at 
least  has  been  given  legal  authority  by  judicial  decisions. 
The  correct  attitude  has  been  taken  in  this  country,  too,  by 
the  Interstate  Commerce  Commission  which  has  adopted  as 
its  rule  the  statement  made  by  P.  D.  Leake:  "  One  of  the 
most  vital  matters  connected  with  productive  industries 
and  trading  concerns  is  the  regular  assessment  with  sub- 
stantial accuracy  of  the  annual  net  profit  or  loss  which  has 
resulted  from  the  operations  of  each  year;  and  unless  a 
near  approximation  to  the  outlay  on  productive  plant 
which  has  expired  within  each  year  is  made  and  fully  pro- 
vided for  out  of  gross  revenue,  no  correct  statement  of 
profit  or  loss  can  be  obtained.  .  .  .  No  Profit  can  exist 
until  Expired  Outlay  on  Productive  Plant  has  been  pro- 
vided out  of  Gross  Revenue."1 

Present  practice  is  unfortunately  not  up  to  this  correct 
principle.  Any  recognition  of  depreciation  at  all  being 
relatively  uncommon  in  the  accounts  of  American  corpora- 
tions, it  is  not  to  be  wondered  at  that  the  few  companies 
which  show  depreciation  in  prosperous  years,  when  profits 
are  large,  grow  faint  hearted  when  business  is  poor.  A 
few  exceptions  are  to  be  noted,  among  which  may  be  men- 
tioned the  Allis-Chalmers  Company  which  in  1906  charged 
nearly  $300,000  to  depreciation,  although  that  resulted  in 
a  total  deficit  of  nearly  $400,000. 

1  Interstate   Commerce    Commission.     Accounting    Series,  Circular 
No.  13. 


DEPRECIATION  137 

Depreciation  should  cover  all  decline  in  value  due  to 
the  use  of  productive  assets.  No  less  than  this  is  required 
by  accounting  prudence.  But  while  this  standard  is  fre- 
quently not  reached,  it  is  not  unusual  to  find  corporations 
charging  to  depreciation  sums  far  in  excess  of  the  actual 
decline  in  value.  Yet  such  excessive  depreciation  offends 
the  very  principles  of  accounting.  To  charge  too  much 
to  depreciation  is  no  less  a  deviation  from  accuracy  than 
to  charge  too  little.  Yet  the  two  transactions  are  very  dif- 
ferently regarded  by  the  public  and  by  the  profession.  To 
charge  too  little  is  considered  dishonorable,  to  charge  more 
than  enough  is  considered  a  sign  of  conservatism  and  is 
not  only  done  by  the  most  reputable  corporations,  but 
where  this  occurs  the  action  is  very  frequently  praised  by 
financial  writers. 

The  effect  of  excessive  depreciation  is  to  conceal  the 
amount  of  profits,  to  create  what  is  known  as  a  "  Secret 
Reserve."  Depreciation  is  normally  charged  to  expense, 
or  at  least  to  Profit  and  Loss.  If,  in  fact,  there  has  been  no 
actual  decline  in  value,  the  result  is  that  the  Balance  Sheet 
shows  an  understatement  of  both  assets  and  profits.  The 
questions  involved  are,  therefore,  those  of  undervaluation 
of  Assets  and  Secret  Reserves  both  of  which  are  elsewhere 
discussed.  Here  it  suffices  to  call  attention  to  the  fact  that 
an  excessive  depreciation,  while  generally  condoned,  is  still 
a  divergence  from  an  ideal  accounting,  and  its  effect  is  the 
establishment  of  a  Secret  Reserve. 

The  question  is  frequently  raised  as  to  whether  depre- 
ciation provides  for  the  replacement  of  the  wasting  article. 
The  question  itself,  although  sometimes  propounded  by 
accountants,  involves  a  misapprehension.  Depreciation  in 
itself  merely  means  that  there  has  been  a  decline  in  the 
value  of  certain  assets.  If  this  results  in  a  net  loss  evi- 
dently there  is  nothing  with  which  to  replace  a  destroyed 
asset.  For  instance,  a  company  with  Plant  $100,000,  Capi- 


138 


MODERN   ACCOUNTING 


tal  $50,000,  and  Debt  $50,000  suffers  a  depreciation  of  two 
per  cent.  If  other  expenses  just  balance  income,  this  means 
a  net  loss  of  $2,000.  The  Balance  Sheet  then  would  read : 


Dr. 


FORM  42. 
Balance  Sheet. 


Cr. 


Plant $100,000 

Less   depreci- 
ation         2,000 


$98,000 
Loss 2,000 

$100,000 


Capital. 
Debt.. 


$50,000 
50,000 


$100,000 


The  plant  is  the  only  possession  of  the  company,  and 
there  are  no  other  free  assets  with  which  the  loss  can  be 
made  good.  But  where,  after  the  deduction  for  deprecia- 
tion, there  is  a  net  profit,  the  case  is  different.  Assuming 
that  the  expenses  other  than  the  depreciation  were  $10,000 
and  the  income  $12,001  the  balance  shows : 


Dr. 


FORM  43. 
Balance  Sheet. 


Cr. 


Plant $100,000 

Less   depreci- 
ation         2,000 


Other  assets . 


$98,000 
2,001 

$100,001 


Capital $50,000 

Debt 50,000 

Profit  and  Loss 1 


$100,001 


In  such  a  case  the  depreciation  account  signifies  that  other 
assets  are  now  held  equal  to  the  depreciation.  Part  of  the 
original  plant  has  disappeared,  but  its  value  is  represented 
by  other  assets.  Evidently  so,  for  if  a  decline  in  the  value 
of  one  asset  has  not  resulted  in  a  net  loss,  there  must,  by 
the  most  fundamental  principle  of  double  entry  bookkeep- 
ing, be  an  equivalent  increase  in  the  value  of  another  asset. 


DEPRECIATION" 


139 


The  presence  of  a  Depreciation  Account  signifies,  then, 
the  substitution  of  some  new,  presumably  some  floating 
asset  in  place  of  part  of  the  value  of  one  of  the  fixed  assets. 
Whether  this  implies  the  presence  of  means  to  replace  the 
old  asset,  or  not,  depends  on  the  interpretation  of  the 
terms  used.  If  the  new  asset  consists  of  cash,  evidently 
there  are  means  on  hand  for  replacement;  if  the  assets 
exist  in  the  form  of  some  new  fixed  asset,  that  in  itself 
does  not  directly  give  ready  money.  Constructively  there 
is  power  to  replace  because  of  the  equivalence  of  assets. 
Practically  that  power  may  be  hindered  by  inability  to 
realize  on  the  asset.  But  a  similar  difficulty  would  exist 
under  any  circumstances;  for  the  existence  of  a  special 
replacement  fund,  composed,  say,  of  stock  exchange  securi- 
ties might  not  always  prevent  difficulty  in  raising  funds  in 
a  pressing  emergency.  The  existence  of  a  depreciation  ac- 
count implies,  except  in  a  Balance  Sheet  showing  a  net  loss, 
the  presence  of  new  assets,  that  is  of  assets  acquired  since 
the  purchase  of  the  plant,  of  equivalent  value.  Whether 
these  new  assets  furnish  means  of  replacement  depends 
on  their  nature  and  the  conditions  of  the  general  market. 

An  apparent  exception  occurs  where  the  new  wealth  is 
used  to  pay  off  a  debt,  when  the  Balance  Sheet  becomes : 


Dr. 


FORM  44. 
Balance  Sheet. 


Cr. 


Plant $100,000 

Less  depreci- 
ation          2,000 


Other  assets . 


$98,000 

1 

$98,001 


Capital $50,000 

Debt 48,000 

Profit  and  Loss 1 


$98,001 


Here  the  cancelation,  presumably,  gives  an  equivalent 
borrowing  power,  and  the  presence  of  additional  assets  or 


140  MODERN   ACCOUNTING 

the  lessening  of  debts  (that  is  the  cancelation  of  negative 
assets)  are  practically  identical. 

In  addition  to  the  loss  from  wear  and  tear  even  material 
goods  are  subject  to  further  depreciation  from  economic 
changes.  This  includes  changes  in  the  residual  value  due 
to  outside  conditions,  and,  if  it  can  be  reckoned,  the  likeli- 
hood that  the  machine  will  be  displaced  by  new  models 
long  before  it  is  worn  out.  Experience  may  show  that  on 
the  average  a  given  class  of  machinery  will  be  serviceable 
for  twenty  years,  but  that  invention  is  so  active  that  it  is 
more  profitable  to  displace  the  machines  and  buy  new 
models  as  often  as  once  in  ten  years.  This  is  confessedly 
vague  and  indefinite,  and  implies  the  ability  to  calculate 
the  future  activities  of  inventive  genius.  The  process  is, 
of  course,  constantly  taking  place.  Indeed,  the  success  of 
American  iron  masters  has  sometimes  been  attributed  to 
the  readiness  with  which  they  discard  serviceable  machines 
in  order  to  install  new  inventions.  If  an  airship  as  now 
made  would  certainly  run  with  undiminished  mechanical 
efficiency  for  thirty  years,  probably  no  one  would  object 
to  the  statement  that  long  before  that  time  the  present 
models  will  be  displaced  by  some  new  and  greatly  im- 
proved type,  and  that  a  calculation  to  that  purport  should 
wisely  be  made.  A  more  practical  illustration  is  found  in 
the  lasts  owned  by  manufacturers  of  shoes.  Materially, 
these  will  serve  for  an  indefinite  number  of  years  without 
destruction.  Practically,  it  is  a  matter  of  certainty  that 
the  present  models  will  be  displaced  by  fashion  long  before 
they  are  worn  out,  and,  as  a  matter  of  fact,  the  accumu- 
lated stock  of  out-of-date  lasts  is  one  of  the  serious  burdens 
of  shoe  factories.  The  same  principle  applies  to  patterns 
used  in  foundries,  sets  of  cards  for  Jacquard  looms,  and 
other  assets  whose  continued  serviceability  is  limited  by  the 
dictates  of  fashion  rather  than  by  wear  and  tear. 

Depreciation  in  all  such  instances  is  scarcely  to  be  dis- 


DEPRECIATION'  141 

tinguished  from  a  reserve  created  to  provide  against  con- 
tingencies. If  the  loss  of  value  is  certain  enough  to  be 
calculable  it  approximates  closely  to  ordinary  deprecia- 
tion ;  if  less  certain  and  yet  not  to  be  neglected  it  resembles 
rather  a  reserve  discussed  in  Chapter  XIII. 

The  depreciation,  or  more  properly  speaking,  the  amor- 
tization of  nonmaterial  assets  is,  of  course,  not  due  to  wear 
and  tear,  but  is  no  less  inevitable.  Where  there  is  a  time 
limit,  as,  for  instance,  in  the  case  of  a  ten  years'  mining 
concession,  the  depreciation  must  be  accomplished  within 
that  period.  In  many  cases  it  is  legitimate  to  charge  off 
the  value  even  more  rapidly.  Thus  a  copyright  is  likely  to 
become  of  little  value  before  its  legal  termination.  One 
general  rule  is  here  applicable,  namely:  The  more  indefi- 
nite or  uncertain  the  value  of  the  asset  the  more  rigid  and 
rapid  should  be  its  depreciation. 

The  application  of  these  general  principles  governing 
depreciation  to  the  various  classes  of  assets,  and  the  de- 
termination of  the  proper  rate  to  be  allowed  in  each  case 
is  a  matter  of  the  greatest  difficulty.  Material  goods  are 
subject  to  depreciation  for  both  physical  and  economic 
causes.  Physical  loss  or  deterioration  is  a  question  whose 
ultimate  decision  is  in  each  case  to  be  based  on  the  opinion 
of  technical  experts.  Only  thus  can  an  estimate,  even 
approximating  correctness,  be  made  of  the  probable  life 
of  the  asset  and  its  residual  value.  The  nature  of  the 
machine,  the  intensity  of  work,  the  amount  of  repairs,  the 
character  of  the  operations,  and  many  other  technical 
matters  enter  into  the  calculation  for  machinery.  Equally 
is  each  building  to  be  considered  by  itself,  for  the  nature 
of  its  construction,  the  use  to  which  it  is  put,  the  climate 
to  which  it  is  exposed,  the  expenditures  to  be  made  in 
repairs,  and  other  items  are  effective  in  determining  its 
duration.  Evidently  in  so  complicated  a  problem,  with  so 
many  uncertain,  if  not  unknown  quantities,  no  one  even 


142  MODERN"   ACCOUNTING 

attempts  minute  accuracy.    All  the  more  need  for  making 
the  calculation  as  carefully  as  possible. 

It  is  impossible  to  lay  down  specific  rates  of  deprecia- 
tion which  would  have  any  absolute  value.  The  following 
figures  are  those  given  by  Dicksee,  and  indicate  roughly 
the  rates  which  are  considered  satisfactory  where  condi- 
tions are  favorable.  In  each  case  the  rates  are  based  on 
the  diminishing  value. 

ASSET  RATE  OF  DEPRECIATION 

Engines    10  -12^  per  cent. 

Boilers    12^-20 

Shafting   5  -  7£ 

General  machinery 7^-10 

Special  machinery  10  -25 

Patterns   25  -33£        " 

Horses 15-25 

Somewhat  similar  tables  are  given  by  Tiffany,  in  which 
greater  attention  is  given  to  buildings,  and  in  which  vari- 
ations are  given  to  correspond  somewhat  with  details  of 
construction.  But  it  must  ever  be  borne  in  mind  that  no 
general  rules  can  be  laid  down  and  each  problem  must 
be  specifically  treated.  This  doctrine  is  admirably  laid 
down  by  the  Interstate  Commerce  Commission  which  when 
asked  to  specify  the  rates  of  depreciation  to  be  charged, 
replied :  ' '  Conditions  under  which  equipment  is  used 
vary  so  greatly  that  no  uniform  rate  of  depreciation  for 
all  roads  could  be  reasonably  determined.  The  proper 
rate  will,  of  course,  vary  inversely  with  the  life  of  the 
property  to  which  it  pertains,  and  its  determination  must 
take  into  consideration  whatever  affects  the  life  of  the 
property.  Each  reporting  officer  should  determine  the 
rate  to  be  used  according  to  such  experience  tables  as  he 
may  be  able  to  construct  from  equipment  records. ' ' l 

1  Accounting  Series,  Circular  No.  12a,  p.  2,  Case  109. 


DEPRECIATION  143 


BIBLIOGRAPHICAL  NOTE  TO   CHAPTER  VII 

DELANO,  F.  A.  The  Application  of  a  Depreciation  Charge  in  Rail- 
way Accounting.  Journal  of  Political  Economy,  XVI,  p.  585. 
[A  criticism  of  the  rules  of  the  Interstate  Commerce  Com- 
mission.] 

DICKSEE,  L.  R.  Depreciation,  Reserves,  and  Reserve  Funds. 
London,  1903.  [An  important  work.] 

GRINLING,  C.  H.  The  Need  of  a  Depreciation  Fund  in  Railway 
Accounts.  Banker's  Magazine  (London),  LXXV,  p.  692. 

GUTHRIE,  E.  Depreciation.  Article  in  Encyclopedia  of  Account- 
ing, III,  p.  357.  [Contains  table  of  rates.] 

MATHESON,  E.  The  Depreciation  of  Factories,  Mines,  and  In- 
dustrial Undertakings  and  Their  Valuation.  Second  edition. 
London,  1903.  [Of  recognized  authority,  dealing  with  the 
subject  from  the  viewpoint  of  the  engineer.] 

TIFFANY,  H.  L.  Digest  of  Depreciation.  Twenty-eighth  edition. 
Chicago,  1890.  [An  elaborate  table  of  estimated  depreciation 
on  various  kinds  of  property,  designed  for  use  of  insurance 
adjusters.] 

TURNER,  S.  H.  Depreciation  and  Sinking  Funds  in  Municipal 
Undertakings.  Economic  Journal,  XIV,  p.  47.  [Discusses 
the  duplication  of  charges  under  the  English  law.] 

UNITED  STATES  INTERSTATE  COMMERCE  COMMISSION.  Classifica- 
tion of  operating  expenses  as  prescribed  by  the  Interstate 
Commerce  Commission.  Third  revised  edition.  Washington, 
1908. 

• Interstate  Commerce  Commission.  Division  of  Statistics 

and  Accounts.  Accounting  Series,  Circulars  Nos.  8  and  13, 
1907.  [The  above  documents  formulate  and  explain  the  rules 
of  the  Commission  applicable  to  railways.] 

WILKINSON,  G.     Depreciation  and  Reserves.    New  York,  1905. 


CHAPTER   VIII 

CAPITAL   STOCK 

I.  Issued  for  Cash 

THE  Capital  account,  in  the  initial  bookkeeping  equa- 
tion, represents  the  net  wealth  of  the  proprietor.  It  shows 
in  a  single  item  the  net  value  of  all  the  items  of  wealth, 
positive  and  negative,  which  are  set  forth  in  detail  in  the 
various  Goods  accounts.  If  the  proprietor  is  an  individual, 
the  opening  entry  in  the  Capital  account  represents  the 
net  wealth  with  which  he  starts  his  business.  If  it  is  a 
partnership,  separate  Capital  accounts  are  established  to 
show  the  amount  contributed  by  each  of  the  partners. 

The  keeping  of  the  Capital  account  of  individuals  or 
partnerships  is  extremely  simple.  The  original  contribu- 
tion made  by  each  of  the  proprietors  is  definitely  known, 
and  there  is  ordinarily  no  doubt  as  to  its  value.  This  orig- 
inal contribution  is  accordingly  credited  to  the  account 
representing  the  capital.  This  is  frequently  headed  with 
the  name  of  the  proprietor,  with  perhaps  a  further  state- 
ment that  it  represents  a  capital  contribution,  and  is  not 
a  loan,  thus:  John  Smith,  Capital  Account.  The  actual 
proprietorship  interest  in  the  business,  however,  necessa- 
rily changes  from  day  to  day  with  each  transaction,  with 
the  incurring  of  each  expense,  the  suffering  of  any  loss,  or 
the  taking  of  a  profit.  While  each  of  these  changes  might 
logically  be  entered  at  once  in  the  proprietor's  Capital 
account,  there  is  good  reason,  as  was  shown  in  Chapter  I, 
for  entering  these  daily  changes  in  temporary  proprietor- 
ship accounts,  which  at  stated  periods,  customarily  at  the 


CAPITAL   STOCK  145 

end  of  the  year,  are  all  gathered  into  the  Profit  and  Loss 
account.  The  balance  of  this  account  shows  the  net  change 
in  the  proprietor's  wealth  which  has  occurred  during 
the  course  of  the  year  through  business  operations,  or  the 
misfortunes  incident  thereto.  When  the  net  change  has 
been  thus  ascertained,  it  is  transferred  to  the  proprietor^ 
Capital  account,  so  that  at  the  end  of  each  year,  as  at  the 
beginning  of  the  business  enterprise,  that  account  shows, 
as  accurately  as  may  be,  the  net  wealth  of  the  proprietor. 
There  is  nothing  fixed,  arbitrary  or  conventional  regard- 
ing the  Capital  account  of  the  private  trader.  If  he  starts 
with  an  investment  of  $10,000  that  amount  appears  as  the 
initial  entry  to  the  credit  of  his  Capital  account.  If  he 
gains  $2,000  profits  during  the  year  and  withdraws  from 
the  business  $1,500  for  outside  use,  the  Capital  account 
is  credited  with  the  former  sum  and  charged  with  the 
latter,  so  that  at  the  beginning  of  the  new  year  his  Capital 
account  again  starts  out  with  a  balance,  $10,500,  which  in 
a  single  sum  represents  the  net  wealth  of  which  he  is  for 
the  moment  possessed.  If  in  the  second  year  the  results 
show  a  loss  of  $1,500  this,  at  the  end  of  the  year,  is  in  turn 
charged  to  the  Capital  account,  which  starts  out  the  new 
year  with  a  balance  showing  that  the  net  wealth  has  been 
reduced  to  $9,000.  From  year  to  year,  then,  the  account 
shows  the  actual  net  wealth,  making  no  discrimination  be- 
tween the  original  capital  contribution,  the  surplus  or 
deficit  due  to  business  operation,  or  the  alterations  due  to 
withdrawals  or  additions  of  capital  by  the  proprietor. 

In  corporations,  however,  the  treatment  of  capital  is 
not  so  simple.  The  original  entry  does  not  necessarily 
represent  the  amount  of  wealth  which  has  been  contrib- 
uted by  the  stockholders;  increments  to  the  net  wealth 
are  not  annually  added  to  the  original  sum,  which  remains 
constant  at  the  par  value.  The  Capital  account  of  a  cor- 
poration represents  only  the  sum  at  which  the  company 


146  MODERN   ACCOUNTING 

is  incorporated,  the  par  value  of  the  Capital  Stock.  The 
actual  present  net  wealth  is  obtained  only  by  combining 
with  this  item  one  or  more  other  accounts,  kept  separate 
on  the  Balance  Sheet  and  in  the  ledger,  which  show  vari- 
ations from  this  nominal  capital  and  alterations  in  it  due 
to  business  operations  and  other  changes. 

The  accounting  problems  having  to  do  with  the  Capital 
account  are  therefore,  mainly,  those  connected  with  the 
capital  of  corporations.  They  arise  generally  from  a  di- 
vergence between  the  nominal  or  par  value  of  the  Capital 
Stock  issued  and  the  actual  net  wealth  of  the  corporation. 
But  even  these  problems  would,  in  most  cases,  cause  no 
difficulty  were  it  not  for  the  further  fact  that  in  many 
cases  the  corporation  is  unwilling  to  show  clearly  its  exact 
condition.  It  may  have  done  some  financing  which  is 
prohibited  by  law,  and  it  then  becomes  a  problem  how  to 
present  the  accounts  in  such  a  way  as  to  conceal  this  ille- 
gal action.  Or  it  may  be  that  not  law,  but  business  pru- 
dence, has  been  violated  and  again  it  becomes  a  problem 
how  to  conceal  this  fact  in  the  company's  Balance  Sheet. 
The  accountant  should  have  no  interest  in  solving  such 
problems,  nor  is  he,  as  an  accountant,  primarily  interested 
in  the  exact  legal  status  of  certain  financial  transactions. 
For  instance,  in  some  states  a  corporation  may  legally  pur- 
chase its  own  stock  in  the  market,  in  others  this  is  pro- 
hibited. In  either  case,  the  accountant,  as  such,  is  con- 
cerned only  in  showing  that  the  purchase  has  been  made, 
not  troubling  himself  as  to  the  legal  problem,  and  still 
less  attempting  to  find  a  way  in  which  to  conceal  the  fact 
that  such  a  purchase  has  been  made.  If  it  is  kept  clearly 
in  mind  that  the  only  legitimate  purpose  of  accounts  is  to 
show  the  truth,  and  if  accounts  are  kept  strictly  to  this 
rigid  standard,  the  problems  of  the  accountant  will  be 
materially  lessened. 

When  a  new  corporation  is  started,  the  first  step,  nor- 


CAPITAL   STOCK  147 

mally,  is  to  secure  subscriptions  for  the  Capital  Stock 
authorized  by  the  charter.  If  such  subscriptions  are  ob- 
tained for  the  full  authorized  capital  of  the  company  the 
initial  condition  is  then  that  the -company  begins  with  an 
authorized  capital  of  a  given  amount,  the  net  wealth  which 
it  represents  being  composed  entirely  of  promises  made 
by  the  subscribers  to  pay  that  amount.  In  this  initial 
stage,  then,  the  Balance  Sheet  is: 

FORM  45. 
Dr.  Balance  Sheet.  Cr. 


Subscriptions $100,000      Capital  Stock $100,000 


This  may  be  assumed  to  be  the  normal  opening  Balance  , 
Sheet  for  a  corporation  where  the  stock  is  fully  subscribed. 
It  is  perfectly  correct,  for  while  no  wealth  has  been  paid 
into  the  treasury  of  the  company,  the  signing  of  the  sub- 
scription list  creates  an  obligation  on  the  part  of  the  sub- 
scriber which  is  legally  collectible  by  the  company.  It  is 
as  truly  an  asset,  as  the  accounts  receivable  or  the  notes 
receivable  held  by  a  merchant. 

As  the  subscriptions  are  called  and  paid,  the  treatment 
is  identical  with  that  of  any  other  form  of  account  receiv- 
able when  it  is  paid  to  the  proprietor.  The  cash  received 
is  debited,  the  subscription  account  is  credited,  and  gradu- 
ally the  item  Subscriptions  disappears  from  among  the 
assets,  and  there  is  substituted  therefor  Cash  or  some  other 
form  of  property. 

But  not  infrequently  the  incorp  orators  desire  to  begin, 
business  without  securing  subscriptions  for  the  entire  au- 
thorized Capital  Stock.  At  the  beginning  of  operations 
the  entire  sum,  here  $100,000,  is  not  needed,  and  it  is 
thought  better  not  to  receive  subscriptions  until  later 

when  it  can  be  profitably  used,  and  when  the  evidence  of 
11 


148 


MODERN   ACCOUNTING 


successful  operation  will  perhaps  make  it  easier  to  secure 
the  desired  subscriptions.  Assuming  that,  of  the  $100,000 
authorized  Capital  Stock,  subscriptions  are  obtained  for 
only  one-half,  or  $50,000,  the  booking  of  the  transaction 
is  variously  made,  the  more  common  forms  being  given 
below. 

FORM  46. 
Dr.  Balance  Sheet.  Cr. 


Cash $50,000 


Capital  paid  in $50,000 


Dr. 


FORM  47. 
Balance  Sheet. 


Cr. 


Cash $50,000 

Unissued  Stock 50,000 

$100,000 


Capital  Stock. 


Dr. 


FORM  48. 
Balance  Sheet. 


$100,000 
$100,000 

Cr. 


Cash 

Unissued  Stock 


$50,000 
50,000 


$100,000 


Capital  Stock 

outstanding.  $50,000 
In  treasury...     50,000 


Dr. 


FORM  49. 
Balance  Sheet. 


$100,000 
$100,000 


Cr. 


Cash $50,000 


$50,000 


Capital  author- 
ized  $100,000 

Ij«ss  amount 
held  in 
Treasury. . .     50,000 


$50,000 
$50,000 


CAPITAL   STOCK  149 

Many  accountants  argue  in  favor  of  the  first  form 
given  above,  saying  that  $50,000  is  all  that  the  company 
has  received,  that  it  is  all  that  serves  as  a  guarantee  to 
creditors;  and  that  the  unsubscribed  and  unissued  stock 
is  virtually  nonexistent.  The  same  idea  is  embodied  in 
some  laws.  In  German  law,  it  is  not  permissible  to  show 
any  capital  not  subscribed  for.  In  Austria  the  law  relat- 
ing to  one  class  of  corporations  definitely  states  that  un- 
issued stock  may  not  appear  either  in  the -Balance  Sheet 
or  in  any  other  statement,  and  the  Companies  Act  of  Que- 
bec, passed  in  1907,  says:  "  Capital  Stock  shall  consist  of 
that  portion  of  the  amount  authorized  by  the  charter, 
which  shall  have  been  bona  fide  subscribed  for  and  al- 
lotted." Despite  such  legally  authoritative  statements 
there  is  some  ground  for  holding  that  Form  46  is  not 
altogether  sufficient. 

The  argument  that  unsubscribed  and  unissued  stock 
must  not  appear  at  all  in  the  accounts  of  the  company 
because  it  is  nonexistent  is  somewhat  specious.  The 
amount  of  depreciation  of  machinery  or  plant  is  no  less 
nonexistent.  Indeed,  unissued  stock  has  a  certain  reality, 
for  it  does  constitute  a  means  by  which,  directors  can,  at 
least  in  times  of  prosperity,  raise  funds,  while  the  depre- 
ciation of  property  represents  an  absolutely  nonexistent 
quantity.  Yet  the  appearance  of  depreciation,  in  the  form 
of  a  Depreciation  Account,  is  a  recognized  and  legitimate 
convention  of  accounting. 

While  unsubscribed  stock  is  not  an  asset  so  far  as  the 
creditor  is  concerned,  yet  the  existence  of  such  stock,  sub- 
ject to  issue  at  the  discretion  of  the  directors,  is  a  matter 
of  which  the  stockholder  should  be  informed.  Perhaps  the 
desired  information  is  sufficiently  given  in  a  foot-note,  or 
other  memorandum  attached  to  the  Balance  Sheet,  which 
is  the  form  used  by  British  companies.  But  to  many  ac- 
countants it  seems  desirable  to  show  the  total  authorized 


150  MODERN   ACCOUNTING 

capital  stock  as  an  item  entering  into  the  accounts  proper, 
with  the  unissued  stock  as  an  item  appearing  elsewhere  in 
the  Balance  Sheet. 

This  may  be  accomplished  in  various  ways,  three  dif- 
ferent methods  of  presenting  the  facts  being  shown  in 
Forms  47-49  above.  The  first  of  these  is  one  very  fre- 
quently found  in  American  reports,  and  exhibits  the  entire 
unissued  stock  as  an  asset.  Not  infrequently  the  term 
"  Treasury  Stock  "  is  used  to  designate  unissued  stock 
thus  held,  a  practice  which  has  been  severely  criticised,  on 
the  ground  that  the  term  Treasury  Stock  should  be  limited 
to  stock  which  has  once  been  issued  and  subsequently  reac- 
quired.  The  objection  is,  however,  made  that  in  this  form 
the  Balance  Sheet  gives  an  exaggerated  and  perhaps  mis- 
leading statement  of  the  actual  capital  of  the  company. 
This  objection  can,  however,  easily  be  removed  by  making 
the  modification  shown  in  Form  48  where  the  total  author- 
ized Capital  Stock  appears  as  a  significant  item  in  the  ex- 
tended column  of  the  Balance  Sheet,  yet  attention  is  called 
to  the  fact  that  part  of  the  stock  is  unsubscribed  and  that 
it  appears  among  the  assets.  But  a  still  better  form  is 
the  last  one  given  above,  where  under  the  general  rule  that 
a  negative  item  can  be  shown  in  the  Balance  Sheet  as  a 
subtraction  (see  page  53  above),  the  Unissued  Stock,  in- 
stead of  appearing  on  the  left  hand  of  the  Balance  Sheet, 
is  subtracted  from  the  item  Authorized  Capital.  This  is 
the  form  used  in  the  Balance  Sheet  of  the  Atchison,  To- 
peka  and  Santa  Fe  Railway,  as  shown  on  page  61. 

It  should  be  noted  that  while  there  may  be  little  differ- 
ence in  the  Balance  Sheet  obtained  in  Form  46  and  that 
in  Form  49,  yet  there  is  a  real  difference  in  the  ledger 
accounts.  In  the  former,  the  original  Journal  entry  pre- 
sumably corresponds  with  the  Balance  Sheet  given;  there 
is  no  account  showing  Unissued  Stock  to  be  found  in  the 
Ledger,  and  the  Capital  Stock  account,  in  the  ledger  shows 


CAPITAL   STOCK 


151 


only  a  credit  of  $50,000.  But  in  all  the  other  forms,  al- 
though presented  differently  in  the  Balance  Sheet,  the 
ledger  entries  are  identical  and  all  differ  from  Form  46, 
for  in  each  instance  Unissued  Stock,  or  some  other  similar 
account,  is  to  be  found  in  the  Ledger  showing  a  debit  bal- 
ance of  $50,000,  and  the  Capital  Stock  account  proper 
shows  a  credit  for  the  entire  $100,000. 

Very  similar  is  the  problem  of  the  treatment  of  the 
capital  stock  which  after  issue  has  been  reacquired  by  the 
company.  Aside  from  the  question  of  the  legality  of  this 
action,  which  is  not  an  accounting  question  at  all,  the  dis- 
cussion turns  on  whether  stock  so  acquired  is  a  real  asset, 
and,  if  so,  how  it  is  to  be  represented  in  the  accounts.  The 
argument  against  the  legitimacy  of  showing  unissued 
stock,  is  also  used,  though  with  less  cogency,  regarding 
repurchased  stock.  In  a  certain  sense  any  return  of  capi- 
tal stock  to  the  issuing  company  may  be  considered  as  a 
virtual  cancelation  of  that  amount  of  the  previously  is- 
sued stock.  That  seems  to  be  the  distinct  attitude  of 
French  law,  and,  according  to  Simon,  is  to  be  inferred 
from,  although  not  clearly  expressed  in,  German  law.  A 
distinction  may  be  made  according  to  the  purpose  for 
which  the  stock  is  acquired.  If  it  is  done  with  the  inten- 
tion of  reducing  the  Capital  Stock,  certainly  the  stock  so 
acquired  and  canceled  should  be  deducted  from  the  amount 
of  outstanding  stock,  and  should  appear  as  below: 


Dr. 


FORM  50. 

Balance  Sheet. 


Cr. 


Plant  and  other  assets.. .  $120,000 

Investments '.  • .      15,000 

Cash 5,000 


$140,000 


Capital  stock 

authorized.. .  $100,000 
Less  canceled 
stock 10,000 


$90,000 
Bonds 50,000 

$140,000 


152 


MODERN   ACCOUNTING 


But  if  the  stock  is  not  acquired  with  the  intent  of  reduc- 
ing the  capitalization,  and  is  not  canceled,  accounting 
practice  in  this  country  certainly  justifies  and,  indeed, 
requires  that  it  be  shown  among  the  assets.  Where  this 
is  the  case  the  best  form  for  presenting  the  Balance 
Sheet  is: 


Dr. 


FORM  51. 
Balance  Sheet. 


Cr. 


Plant,  efc $120,000 

Investments 15,000 

Treasury  Stock 10,000 

Cash 5,000 


$150,000 


Capital  Stock 

outstanding....  $90,000 
Held  in  Treasury.  10,000 

~  $100,000 
Bonds 50,000 

$150,000 


which  is  the  form  used  in  the  accounts  of  the  Chicago  and 
Northwestern  Railway.  There  is,  however,  no  criticism  of 
an  alternative  form,  which  indeed  some  prefer,  in  which 
the  item  is  not  listed  among  the  assets,  but  appears  as  a 
deduction  from  the  total  capital  stock  on  the  liabilities  side, 
thus  resembling  Form  49. 

It  is,  however,  misleading,  and  hence  incorrect,  to  allow 
the  stock  held  in  the  treasury  to  be  included  in  some  gen- 
eral designation  which  does  not  clearly  show  that  it  is 
the  company's  own  stock.  In  the  statement  above,  to  in- 
clude both  Investments  and  Treasury  Stock  under  the  sin- 
gle title  Investments  would  be  thus  misleading.  This  de- 
cidedly objectionable  form  is  not  infrequently  used,  and 
occasionally,  it  may  be,  to  the  deception  of  creditors. 

The  use  of  the  phrase  Treasury  Stock  to  designate  live 
stock  reacquired  by  the  issuing  company  is  thoroughly 
recognized  in  this  country,  although  the  term  seems  not 
to  be  used  in  England,  nor  are  equivalent  terms  used  in 
France  and  Germany.  Some  writers  claim  that  this  is  th<» 


CAPITAL   STOCK  153 

only  proper  use  of  the  term,  and  that  to  apply  it  to 'unis- 
sued stock  is  incorrect.  An  examination  of  American  bal- 
ance sheets  will  give  numerous  instances  where  Treasury 
Stock  is  used  as  including  unissued  stock.  But  there  is 
an  important  difference  between  reacquired  and  unissued 
stock  in  that  the  former  can  legally  be  sold  by  the  com- 
pany below  par  without  making  the  purchaser  liable  for 
the  discount.  To  indicate  this  distinction  would  seem  de- 
sirable in  accounting,  and  this  could  easily  be  done  by 
limiting  the  term  Treasury  Stock  in  the  way  mentioned  -r 
and  calling  stock  which  has  not  been  issued  or  subscribed 
for  by  some  other  designation,  e.  g.,  Unissued  Stock. 

Altogether  different  from  the  foregoing  cases  is  the 
company  which  has  received  subscriptions  for  all  of  its 
capital  but  has  not  yet  called  for  payment  of  the  whole 
amount  subscribed.  If,  for  instance,  the  capital  stock  of 
$100,000  has  been  all  subscribed  for,  but  only  $50,000  has 
been  called  in,  it  is  really  incorrect  to  present  the  capital 
as  only  $50,000  and  the  assets  of  the  same  amount  without 
reference  to  the  uncalled  subscriptions.  Yet  practice  is 
not  uniform  on  this  point,  and  to  what  extent  the  uncalled 
subscriptions  are  to  be  included  in  the  accounts  proper, 
and  how  far  they  are  only  to  be  referred  to  as  an  explana- 
tory item  is  not  uniformly  agreed  upon.  In  England  the 
standard  form  for  Balance  Sheets,  that  which  until  re- 
cently was  given  as  a  model  in  Table  A  of  the  Companies 
Act  (see  page  66),  excludes  the  uncalled  subscriptions 
from  the  accounts  proper,  the  form  used  being: 

FORM  52. 
Liabilities 

Nominal  capital  (10,000  shares  of  £10  each) £100,000 


Capital  called  up  (£5  per  share) £50,000 

Less  calls  in  arrears 100 


Capital  paid  in £49,900 


154 


MODERN   ACCOUNTING 


In  this  the  Nominal  Capital  is  no  part  of  the  Balance  Sheet 
proper,  and  a  distinction  is  further  made  between  uncalled 
subscriptions  and  those  called  but  in  arrears.  The  capital 
actually  paid  in  alone  shows  in  the  extended  column. 

In  France,  however,  the  uncalled  subscriptions  appear 
generally  as  an  asset;  and  in  Germany,  while  not  always 
shown,  the  omission  is  said  by  Rehm  to  be  contrary  to  both 
law  and  principle.  In  this  country  it  is  less  common  to 
issue  stock  not  fully  paid  up,  but  the  propriety  of  show- 
ing the  uncalled  subscriptions  as  assets  is  backed  by  the 
authority  of  the  frequently  cited  case  of  See  v.  Heppen- 
heimer  stating  explicitly  that  it  is  a  "  rule  of  the  common 
law  that  the  unpaid  subscriptions  to  the  capital  stock  of 
a  corporation  form  an  asset  for  the  payment  of  the  debts 
thereof."  Where  the  calls  are  in  arrears  it  may  be  better 
to  indicate  that  fact  clearly,  as  is  done  in  the  English  form 
above,  on  the  principle  that  a  call  in  arrears  is  of  doubtful 
value  at  best.  Either  of  the  forms  given  below  is  satisfac- 
tory. 


Dr. 


FORM  53. 
Balance  Sheet. 


Cr. 


Cash $50,000 

Uncalled  subscriptions . .      50,000 


$100,000 


Capital  fully  subscribed 

Paid  in $50,000 

Subscriptions  uncalled     50,000 

$100,000 


or: 


Dr. 


FORM  54. 
Balance  Sheet. 


Cr. 


Cash $50,000 


$50,000 


Capital  fully  subscribed..  $100,000 
Less  subscriptions  un- 
called       50,000 

Capital  paid  in $50,000 

$50,000 


CAPITAL    STOCK  155 

It  is  sometimes  stated  that  it  is  illogical  to  include  the 
contingent  asset  of  uncalled  subscriptions  in  the  Balance 
Sheet,  since,  as  a  rule,  neither  contingent  assets  nor  lia- 
bilities are  taken  into  account.  Thus,  in  the  case  of  a  bank, 
where  the  stockholder  who  has  paid  up  his  subscription 
in  full  is  liable  to  a  further  assessment  of  100  per  cent,  if 
that  is  needed  to  pay  off  creditors,  this  additional  contin- 
gent asset  is  never  included  in  the  Balance  Sheet.  But 
there  is  a  marked  difference ;  the  additional  liability  of  the 
shareholders  of  a  bank  is  only  available  in  case  of  insolv- 
ency, while  the  subscriptions  are  an  asset  on  which  the 
directors  can  at  any  time  call,  and  are  therefore  more 
evidently  an  item  to  appear  in  the  Balance  Sheet. 

Subscriptions  to  capital  stock  are  not  infrequently  made 
at  a  premium.  This  is  particularly  common  in  the  case 
of  banks,  where  for  one  or  another  reason  the  institution 
prefers  to  start  in  with  assets  in  excess  of  the  nominal 
capital.  It  is  also  common  where  an  established  company 
increases  its  capital  stock  in  circumstances  which  make 
investors  glad  to  pay  a  premium  for  a  share  in  an  enter- 
prise which  is  already  eminently  successful.  In  all  such 
cases  the  premium  is  economically  a  capital  contribution 
and  nothing  else ;  but  the  requirement  that  the  capital  ap- 
pear at  its  par  value  makes  it  necessary  to  enter  the  sum 
thus  paid  under  some  other  head.  The  customary  title  is 
"  Surplus  "  which  is  the  term  always  used  by  National 
banks,  which  frequently  capitalize  thus  in  order  to  escape 
the  necessity  of  annually  withholding  one  tenth  of  the 
profits  to  form  a  compulsory  reserve  amounting  to  twenty 
per  cent,  of  the  nominal  capital.  The  only  alternative  to 
crediting  the  premium  to  Surplus,  or  some  practically 
identical  account  such  as  Reserve,  is  to  credit  it  to  Profit 
and  Loss,  a  procedure  which  is  positively  prohibited  by 
German  law,  permissible  under  English  law,  but  in  any 
case  condemned  by  business  prudence  in  all  countries.  The 


156  MODERN   ACCOUNTING 

premiums  being  no  part  of  the  real  profits  of  the  business 
should  be  specially  held  in  some  account  which  indicates 
that  it  is  not  intended  for  distribution  in  dividends. 

At  times  the  accountant  meets  difficulty  in  determining 
whether  or  not  a  premium  has  been  paid  on  the  stock,  and 
this  unavoidable  uncertainty  is  sometimes  used  as  a  means 
of  showing  an  apparent  surplus  when  none  exists.  To  take 
a  familiar  illustration,  a  company  is  organized  with  Capi- 
tal Stock,  of  $100,000.  A  contract  is  made  whereby  an 
owner  of  a  plant  agrees  to  turn  over  his  property  valued 
nominally  at  $90,000,  and  $9,000  cash  in  return  for  $90,- 
000  stock.  The  interpretation  of  this  transaction  fre- 
quently made  is  that  the  cash  contributed  is  a  premium 
on  the  stock.  A  more  conservative  interpretation  is  that 
the  real  value  of  both  plant  and  cash  is  only  $90,000,  so 
that  no  surplus  exists.  Sometimes  an  attempt  is  made  to 
base  the  interpretation  of  the  transaction  on  the  terms  on 
which  the  other  stock  is  placed.  If  this  is  subscribed  for, 
the  subscription  to  be  paid  in  cash  at  the  rate  of  110,  the 
presumption  is  evident  that  the  stock  given  in  exchange 
for  the  plant  and  cash  was  also  really  taken  at  a  premium 
of  practically  that  percentage,  and  that  the  surplus  really 
exists.  But  even  this  criterion  is  faulty.  The  company 
might  be  capitalized  say,  at  $90,100,  of  which  $90,000  is 
given  in  exchange  for  the  plant  and  $10,000  cash.  It 
would  be  a  simple  matter  for  the  promoters  to  subscribe 
for  the  remaining  $100,  at  110,  or  at  any  other  exorbi- 
tant rate,  if  by  so  doing  they  could  establish  the  surplus 
which  is  claimed  in  the  purchase  of  the  property.  The 
reality  of  a  claimed  surplus  is,  therefore,  not  to  be  estab- 
lished by  any  such  simple  rule  of  thumb,  but  can  be  deter- 
mined only  by  a  careful  estimate  of  the  real  value  of  that 
which  is  given  in  payment  of  the  subscription. 

Thus  far 'it  has  been  assumed  that  all  subscriptions  for 
Capital  Stock  are  to  be  paid  in  full  at  some  time.  This 


CAPITAL   STOCK  157 

is  the  well-established  principle  which  has  been  accepted 
by  all  courts.  But  in  some  instances  a  distinction  has  been 
made  between  stock  subscribed  for,  and  stock  sold  in  the 
market.  A  subscription  not  paid  in  full  carries  with  it 
a  corresponding  liability  to  pay  the  unpaid  portion,  which 
from  the  point  of  view  of  the  corporation  constitutes  an 
asset.  Yet  in  some  circumstances  the  courts  have  allowed 
the  sale  of  stock  for  less  than  par,  the  stock  to  appear  as 
full  paid.  The  most  important  case  on  the  subject  is  that 
of  Handley  v.  Stutz  (139  U.  S.,  417  (1891) ).  In  this  case 
an  embarrassed  company  sold  some  of  its  stock  for  less 
than  par  in  order  to  raise  funds  to  enable  it  to  carry  on 
its  business.  The  court,  while  upholding  the  general  prin- 
ciple that  creditors  have  a  right  to  rely  on  the  subscribers 
having  paid  par  for  their  stock ;  nevertheless,  in  the  excep- 
tional case  of  a  going  concern  which  cannot  place  its  stock 
at  par,  sanctions  selling  it  at  the  best  price  obtainable. 
It  should  be  noted  that  this  decision  applied  only  to  excep- 
tional conditions;  that  Chief  Justice  Fuller  gave  a  very 
able  dissenting  opinion;  that  Justice  Brown,  who  himself 
rendered  the  decision,  declared  in  the  later  case  of  Cam- 
den  v.  Stuart  (144  U.  S.,  104  (1892)),  that  it  must  not  be 
used  to  evade  the  obligation  of  subscribers  to  pay  for  stock 
which  obligation  "  cannot  be  defeated  by  a  simulated 
payment  of  such  subscription,  nor  by  any  device  short  of 
an  actual  payment  in  good  faith  ' ' ;  and  that  an  able  legal 
critic  has  declared  that,  ' '  the  reason  and  conscience  of  the 
profession  have  been  shocked  at  the  doctrine  "  enunciated 
in  Handley  v.  Stutz.1 

In  the  state  courts,  moreover,  it  has  recently  been  held 
that  "  one  who  receives  stock  as  full  paid  without  paying 
for  it  occupies  the  position  of  a  subscriber  who  has  not 
paid  his  subscription."  (See  v.  Heppenheimer,  61,  Atl. 
859.)  In  England,  too,  the  highest  court  has  given  a  most 

i  E.  W.  Huffcut,  26  Am.  Law  Rev.  865. 


158  MODERN   ACCOUNTING 

drastic  decision  in  Ooregum  Gold  Mining  Company  of 
India  v.  Roper  ([1892]  A.  C.,  125),  where  the  House  of 
Lords  held  that  when  a  corporation  sells  its  new  stock 
below  par— even  though  at  double  what  the  old  stock 
commands  in  the  market— the  purchasers  are  liable  for  the 
discount  to  the  corporation  as  well  as  to  the  creditors  of 
the  company.  In  this  decision  the  Lord  Chancellor  said : 
"  It  may  be  that  such  limitations  on  the  power  of  the 
company  to  manage  its  own  affairs  may  occasionally  be 
inconvenient,  and  prevent  its  obtaining  money  for  the 
purposes  of  its  trading  on  terms  so  favorable  as  it  could 
do  if  it  were  more  free  to  act.  But,  speaking  for  myself, 
I  recognize  the  wisdom  of  enforcing  on  a  company  the 
disclosure  of  what  its  real  capital  is  and  not  permitting 
a  statement  of  its  affairs  to  be  such  as  may  mislead  and 
deceive  those  who  are  either  about  to  become  its  share- 
holders or  about  to  give  it  credit." 

In  England,  too,  statute  law  requires  the  payment  of 
full  cash  value  for  stock,  save  that  when  the  articles  of  the 
company  make  special  provisions  therefor,  the  Companies 
Act  of  1900  allows  the  payment  of  a  commission  for  the 
placing  of  shares.  But  in  the  revision  of  the  Act  in  1907 
an  amendment,  which  had  passed  the  House  of  Lords,  gen- 
erally authorizing  the  issue  of  shares  of  established  com- 
panies below  par,  was  rejected  by  the  Commons,  and  with- 
drawn by  the  Lords.  », 

But  where,  for  any  reason  the  stock  is  issued  for  a  less 
amount  of  cash  than  the  par  value,  and  the  courts  free 
the  purchaser  from  any  liability  for  demand  for  further 
payments,  the  accounting  is  still  a  simple  matter.  If  cash 
has  not  been  paid  in  full,  and  if  the  remaining  percentage 
is  not  a  claim  against  the  holder  to  appear  as  an  asset  of 
the  company,  the  only  alternative  is  that  it  must  appear 
as  a  discount  on  the  issue  of  the  stock,  and  must  be  treated 
similarly  to  the  discount  taken  off  a  note  or  bill  discounted. 


CAPITAL   STOCK  159 

There  may  be  some  question  as  to  whether  the  discount 
should  immediately  be  charged  to  the  Profit  and  Loss  ac- 
count, or  whether  it  may  be  placed  as  a  charge  elsewhere. 
But  there  is  no  dispute  that  a  cash  discount  on  stock  is- 
sued must  clearly  show  in  the  accounts  of  the  company, 
and  such  is  the  practice  wherever  discounting  is  openly 
allowed,  as,  for  instance,  in  the  limited  cases  in  England, 
or  in  certain  companies  in  Austria.  The  understanding 
of  this  simple  statement  opens  the  way  for  a  discussion 
of  the  more  difficult  problem  of  the  method  of  treating 
stock  issued  not  for  cash,  but  in  purchase  of  property 
which  is  found  in  the  following  chapter. 

The  reduction  in  the  amount  of  Capital  Stock,  at  least 
when  performed  directly,  offers  no  particular  problem  of 
accounting.  If  it  is  decided  to  reduce  the  capital,  as- 
suming that  the  legal  requirements  are  complied  with,  the 
booking  is  identical  with  that  in  case  of  the  payment  and 
cancelation  of  any  other  credit  balance,  the  cash  paid 
out  and  the  reduction  of  the  liability  balance  offsetting 
each  other.  Or,  if  the  stock  retired  is  redeemed  not  with 
cash  but  with  bonds,  as  was  the  case  in  the  refunding  oper- 
ations of  the  United  States  Steel  Corporation,  the  bonds 
paid  out  offset  the  Capital  Stock  retired,  just  as  in  a  mer- 
chant's books  the  Bills  Payable  given  to  a  creditor  offset 
the  amount  previously  standing  as  an  account  payable. 
But  at  times  the  retirement  of  the  stock  is  made  dependent 
on  the  existence  of  surplus  profits,  and  the  payment  to  the 
stockholders  is  treated  as  if  it  were  actually  a  charge 
against  profits.  Provision  for  the  retirement  of  stock  may 
be  made  in  precisely  the  same  manner  as  is  the  payment 
of  bonds  by  a  sinking  fund,  as  described  fully  in  Chapter 
XIV.  Evidently  the  same  difficulty  arises  in  either  case. 
If  the  retirement  of  capital,  not  being  a  loss  transaction 
is  yet  charged  against  profits,  there  must  be  created  a 
corresponding  credit,  sometimes  called  Ketired  Stock, 


160 


MODERN   ACCOUNTING 


sometimes,  more  correctly,  "  Reserve  created  by  the  re- 
tirement of  capital  out  of  profits."  In  any  event  when 
the  stock  has  been  purchased  for  the  purpose  of  reducing 
the  amount,  it  is  misleading  to  carry  the  canceled  stock 
among  the  assets.  The  Capital  Stock  account  should  itself 
be  debited,  for  whatever  argument  there  may  be  in  favor 
of  carrying  live  Treasury  Stock  as  an  asset,  there  can  be 
none  in  favor  of  retaining  stock  which  has  actually  been 
canceled.  Such  stock  is  certainly  nonexistent. 

Where  the  stock  is  reduced  not  by  purchase  but  by 
surrender  of  part  of  their  holdings  on  part  of  the  stock- 
holders, sometimes  the  case  where  the  company  has  met 
with  losses  and  desires  to  remove  the  deficit  from  the  Bal- 
ance Sheet,  the  reduction  of  the  capital  acts  to  create  a 
corresponding  Surplus.  This  may  be  used  as  a  fund  to 
which  the  existing  deficit,  if  such  there  be,  is  charged.  To 
illustrate :  a  company  with  the  following : 


Dr. 


FORM  55. 
Balance  Sheet. 


Cr. 


Assets $140,000 

Deficit 10,000 

$150,000 


Capital  Stock $150,000 


$150,000 


arranges  with  the  stockholders  to  surrender  twenty  per 
cent,  of  their  holdings  to  cover  the  deficit  and  provide  a 
surplus.  After  the  reduction  of  the  capital  stock  the  books 
would  show: 

FORM  56. 
Balance  Sheet. 


Dr. 


Cr. 


Assets $140,000 


$140,000 


Capital  Stock $120,000 

Surplus 20,000 

$140,000 


CHAPTER   IX 

CAPITAL   STOCK 

II.    Issued  for  Property,  etc. 

THE  subscription  to  stock  demands  the  payment  of  its 
full  par  value,  and  there  being  ' '  in  equity,  no  distinction 
between  a  party  who  makes  a  formal  subscription  for 
stock  and  fails  to  pay  for  it  and  one  who  accepts  a  full 
paid  certificate  without  paying  for  it,"  there  is  the  gen- 
eral assumption  that  all  stock  issued,  with  certain  minor 
exceptions  noted  in  the  preceding  chapter,  is  to  be  paid 
for  in  full  value.  "Where  the  payment  is  to  be  made  in 
cash  the  verification  of  this  assumption  is  easy  and  sim- 
ple. The  real  difficulty  comes  where  stock  is  issued  in 
exchange  for  property.  Here,  too,  the  general  assumption 
is  that  full  value  is  given.  As  has  been  clearly  stated  in 
New  Jersey,  "  the  distinction  between  the  contemplated 
issue  of  corporate  stock  for  property  and  its  issue  for 
money  lies  not  in  the  rule  for  valuation  but  in  the  fact 
that  different  estimates  may  be  formed  of  the  value  of 
property."  (Donald  v.  American  Smelting  and  Refining 
Company,  48  All.  772.)  Such  undoubtedly  should  be  the 
case  from  'the  accounting  view  point,  as  well  as  in  law. 
The  accountant  recognizes  no  difference  between  things  of 
the  same  value,  for  it  is  the  money  value  of  goods  and  of 
capital  in  which  he  deals. 

Unfortunately,  in  practice,  very  different  principles 
prevail.  Not  only  is  stock  time  and  again  issued  for  prop- 
erty, which  in  the  mind  of  every  one  concerned  is  worth 
much  less  than  par  value  of  the  stock  with  which  it  is 

161 


162  MODERN   ACCOUNTING 

purchased,  but  the  very  terms  of  the  sale  give  conclusive 
evidence  to  the  general  public  that  there  has  been  gross 
overvaluation.  The  reason  that  this  is  so  is  that  there 
is  lacking  any  satisfactory  criterion  as  to  the  real  value 
of  the  property  purchased  with  stock.  Such  purchases 
are  frequently  large  plants,  as,  for  instance,  the  manu- 
facturing establishments  bought  by  any  of  the  "  trusts." 
Including,  as  it  may,  land,  buildings,  machinery,  raw  ma- 
terials, finished  goods,  mercantile  credits,  goodwill,  per- 
haps also  mines  and  quarries,  railroads  and  steamers,  and 
any  other  forms  of  assets,  it  is  clearly  impossible  to  form 
an  authoritative  estimate  of  the  value  of  the  plant.  For 
such  a  complicated  property  there  can,  of  course,  be  no 
publicly  quoted  price,  nor  can  any  reliance  be  placed  on 
its  cost  to  the  vendor,  for  he  may  have  acquired  it  either 
at  an  exorbitant  price,  or  at  a  bargain  sale  far  below  its 
real  value.  The  courts,  therefore,  are  inclined  to  be  lib- 
eral, and  to  leave  the  determination  of  value  in  all  such 
cases  to  the  discretion  of  the  officers  of  the  company.  An 
illustration  of  the  extent  to  which  this  deference  to  the 
directors'  discretion  may  go  is  found  in  a  decision  of  one 
of  the  Federal  courts  to  the  effect  that  the  purchase  by 
a  corporation,  for  $200,000  bonds  and  $3,600,000  stock,  of 
a  railroad  bed,  the  construction  of  which  cost  $2,000  and 
for  which  the  vendor  had  paid  $15,000,  was  not,  on  the 
face,  a  fraudulent  transaction.  (Stewart  v.  St.  Louis,  etc., 
R.  R.  41  Fed.  Rep.  736  (1887).)  , 

But  the  accounting  point  of  view  is  not  necessarily  the 
same  as  the  legal.  The  fact  that  the  court  cannot  deter- 
mine the  real  value  of  the  purchased  property,  has  nothing 
to  say  as  to  how  the  accountant,  knowing  the  value,  should 
enter  it  in  the  books  and  exhibit  it  in  the  Balance  Sheet. 
Yet  the  accountant  is  greatly  influenced  by  the  attitude 
of  the  courts  on  these  matters,  and  it  is  necessary  to  con- 
sider some  of  the  rules  which  the  courts  have  laid  down. 


CAPITAL   STOCK    '  163 

"Where  the  purchased  property  is  worth  the  par  value 
of  the  stock  there  is  no  difficulty  whatever.  The  exchange 
of  stock  for  an  equal  value  of  any  kind  of  property,  is,  to- 
the  accountant,  no  whit  different  in  principle  from  the 
purchase  of  merchandise  by  means  of  a  promissory  note. 
Where,  however,  the  property  is  worth  less  than  the  par 
value  of  the  stock  with  which  it  is  purchased,  the  courts 
have  attempted  to  discriminate  between  cases  where  the 
property  is  not  even  worth  the  supposed  market  value  of 
the  stock,  and  those  where  it  equals  the  market  though 
still  below  the  par  value.  While  the  issue  of  stock  at  less- 
than  its  market  value  has  been  condemned,  the  courts  have 
justified,  especially  in  an  emergency,,  the  issuing  of  stock 
below  par  when  it  was  shown  to  have  been  issued  at  ita 
full  market  value.  This  is  consistent  with  the  decision 
quoted  above,  that  in  emergency  even  stock  issued  for  cash 
may  be  placed  at  less  than  its  face  value.  Evidently  it  is 
much  more  difficult  to  interfere  with  the  issue  of  stock  for 
property,  with  all  the  difficulties  of  appraising  the  prop~ 
erty,  than  when  it  is  issued  for  cash,  which  makes  any  dis< 
count  manifest.  It  is  furthermore  argued  by  the  courts, 
that  no  one  has  been  injured,  and  that,  oftentimes,  if  par 
were  required,  it  would  be  impossible  to  issue  the  stock  at 
all,  since  no  one  would  be  willing  to  take  it  on  that  basis. 

The  latter  argument,  however,  involves  an  economic 
fallacy,  for  it  assumes  that  the  only  way  in  which  an  em- 
barrassed corporation  can  acquire,  say,  $10,000  worth  of 
property  is  by  issuing  stock  of  a  greater  par  value.  This 
assumption  is  unfounded  in  logic  or  experience,  save  as 
reliance  is  placed  on  the  meager  experience  of  American 
corporations  in  recent  years.  To  illustrate,  there  may  be 
taken  the  case  of  a  corporation  with  $60,000  capital  stock 
and  earning  $3,000  yearly.  Considering  the  nature  of  the 
business  this  profit  may  be  insufficient,  and  the  stock  may 
sell  below  par.  But  the  directors  see  that  by  acquiring: 


164  MODERN   ACCOUNTING 

certain  additional  property,  worth  only  $30,000  the  net 
profits  may  be  raised  to  $6,000.  But  the  owner  of  the 
property  is  unwilling  to  sell  his  property  for  $30,000  of 
the  stock  of  the  company.  Is  there,  therefore,  no  other 
way  to  acquire  the  property  than  by  increasing  the  amount 
of  the  capital  stock  to  be  issued,  making  it  $40,000  ?  This 
is  the  position  taken  by  the  courts.  But  the  owner's  un- 
willingness to  take  $30;000  stock  for  his  property,  is  due 
to  the  fact  that  this  would  entitle  him  merely  to  a  f  in- 
terest in  the  earnings  of  the  company,  and  the  prospect  of 
getting  $2,000  is  not  sufficient  to  induce  him  to  take  the 
risk.  The  reason  why  he  would  sell  the  property  for 
$40,000  stock  is  that  such  a  deal  would  give  him  a  right  to 
•fo  of  the  earnings,  and  a  chance  of  receiving  $2,400  is  a 
sufficient  inducement  to  him.  But  it  does  not  therefore 
follow  that  the  company  need  issue  $40,000  stock  for  the 
property  worth  only  $30,000.  Two  other  methods  of  se- 
curing the  end  are  open  to  the  company.  The  stockhold- 
ers might  agree  to  contribute  -^  of  their  holdings  and  to 
give  this  $24.000  of  stock  in  purchase  of  the  property, 
which  should  be  a  satisfactory  inducement  to  the  vendor, 
as  that  would  give  him  exactly  the  same  relative  rights  as 
though  he  had  received  a  new  issue  of  $40,000.  Or  if  that 
wrere  not  possible,  a  simpler  method  is  open  of  issuing  new 
Preferred  Stock  of  $30,000  bearing  cumulative  dividends 
of  say,  8  per  cent.  This  again  would  bring  the  same  re- 
turns to  the  holder  as  would  $40,000  new  Common  Stock. 
It  might  even  be  issued  with  a  smaller  preferred  dividend, 
possibly  7|  per  cent.,  as  the  greater  security  would  allow 
some  reduction  in  the  returns.  Thus  it  is  quite  easy  to 
issue  stock  in  such  a  form  as  to  make  a  smaller  amount 
equally  as  attractive  as  an  excessive  amount  of  a  less  fa- 
vored issue.  Nor  is  this  a  method  which  is  merely  theo- 
retically possible.  It  is  currently  followed  in  Germany 
where  the  issue  of  stock  in  excessive  amounts  is  rendered 


CAPITAL   STOCK  165 

difficult  by  legal  prescriptions,  but  where  corporations  do 
occasionally  become  embarrassed  and  need  to  obtain  funds 
on  unfavorable  terms.  The  provisions  of  Massachusetts 
law  looking  toward  the  issue  of  ' '  special-preferred  ' '  stock 
are  of  similar  purport. 

But  aside  from  the  faulty  economic  assumption  implied 
in  the  legal  doctrine  here  discussed,  the  accountant  objects 
seriously  to  the  theory  that  to  the  corporation  itself  the 
new  stock  can  have  a  value  below  par.  Stock  perhaps 
should  not  be  said  to  have  a  "  nominal  "  value,  but  to 
have  a  par  value,  of  $100.  That  is  to  say  that  the  value 
of  the  stock  should  be  equal  to  100  cents  on  the  dollar. 
The  Balance  Sheet  should  show  the  real  condition,  and 
with  certain  technical  forms  understood,  the  statement 
that  a  company  has  $100,000  Capital  Stock  should  mean, 
and  mean  only,  that  it  has  $100,000  net  assets.  To  speak 
of  a  corporation  issuing  stock  at  its  market  value,  but  at 
less  than  par  should  be  considered  self-contradictory.  The 
expression  "  Capital  Stock  "  means  Proprietorship  of  the 
amount  stated,  and  to  say  that  the  receipt  of  less  assets  is 
still  payment  in  full  is  surely  misleading. 

Indeed  this  peculiar  doctrine  of  distinguishing  be- 
tween the  real  value  and  the  par  value  of  newly  issued 
stock  is  criticised  even  from  the  legal  point  of  view,  as, 
for  instance,  the  ' '  Cyclopedia  of  Law  and  Procedure  ' ' 
states  that  the  Supreme  Court  of  the  United  States,  in 
sanctioning  the  gratuitous  issue  of  stock  because  it  "  was 
without  value  "  refused  to  "  follow  the  decisions  of  the 
highest  courts  in  the  states  construing  their  own  statutes," 
and  that  the  opinion  in  Handley  v.  Stutz,  already  cited, 
"  is  a  departure  from  the  general  current  of  authority 
as  it  stood  at  the  time." 

Fortunately  there  is  evidence  of  a  tendency  toward 
greater  strictness  both  in  legislation  and  in  court  decisions. 
Especially  in  New  Jersey,  which  has  had  a  perhaps  un- 


166  MODERN   ACCOUNTING 

merited  reputation  for  looseness  in  corporation  finance, 
has  there  been  a  clear  enunciation  of  the  correct  princi- 
ples both  in  the  pages  of  the  statutes  and  in  the  interpre- 
tation of  the  judges.  A  series  of  the  decisions  of  the  high- 
est court  of  that  state  illustrates  this.  In  Wetherbee  v. 
Baker  it  was  said  that  "  the  courts  have  inflexibly  en- 
forced the  rule  that  payment  of  stock  subscriptions  is  good 
as  against  creditors  only  where  payment  has  been  made 
in  money,  or  in  what  may  fairly  be  considered  as  money's 
worth  "  (35  N.  J.  Eq.  513  (1882) ).  Ten  years  later  it  held 
that :  "  to  justify  a  corporation  in  issuing  stock  under  our 
act  for  property  purchased  there  should  be  an  approxima- 
tion at  least  in  true  value  of  the  thing  purchased  to  the 
amount  of  the  stock  which  it  is  supposed  it  represents." 
(Edgerton  v.  Electric  Improvement,  etc.,  Co.,  50  N.  J. 
Eq.  361).  Again,  after  nearly  a  decade,  it  was  held  in 
Donald  v.  American  Smelting  and  Refining  Company,  that 
where  the  overissue  is  based  on  a  false  estimate  on  the  part 
of  the  directors,  "  their  honest  judgment,  if  reached  with- 
out due  examination  into  the  elements  of  value,  or  if  based 
in  part  upon  an  estimate  of  matters  which  really  are  not 
property,  or  if  plainly  warped  by  self-interest  may  lead 
to  a  violation  of  this  statutory  rule  as  surely  as  would 
corrupt  motive"  (48  Atl.  Rep.  772  (1901)).  And  in 
See  v.  Heppenheimer  it  was  stated  that  "  although  this 
practice  [issuing  stock  in  excess]  has  been  frequently  in- 
dulged in  and  has  brought  obloquy  upon  our  state  and 
its  legislation  .  .  .  such  practice  is  entirely  unwarranted 
by  anything  either  in  our  statutes  or  in  the  decisions  of 
our  courts;  and  whenever  it  has  been  indulged  in  it  has 
involved  a  clear  infringement  of,  if  not  a  fraud  upon  the 
plain  letter  and  spirit  of  our  legislation."  In  England, 
too,  there  is  the  recent  very  interesting  dictum  of 
Vaughan  Williams  L.  J.  "I  hope  that  the  day  may  come 
when  it  will  be  gravely  considered  by  the  legislature 


CAPITAL   STOCK  167 

wnether  it  is  not  for  the  advantage  of  the  community 
that  an  act  should  be  passed  that  in  all  cases  the  full 
nominal  value  of  the  shares  shall  be  paid  in  cash  and  noth- 
ing else."  (Moseley  v.  Koffyfontein  Mines,  Lim.  [1904] 
2  Ch.  117.) 

To  the  accountant,  however,  the  problem  is  simpler 
than  to  the  jurist.  Two  facts,  one  economic  or  financial,, 
the  other  legal,  he  needs  to  know,  and  knowing  these  the 
method  of  entering  the  transactions  is  already  determined. 
The  first  is,  How  much  was  actually  paid  for  the  stock? 
If  less  than  par  that  difference  must  appear  in  his  ac- 
counts. The  equivalence  of  Goods  to  Proprietorship  must 
be  maintained,  and  where  there  is  an  admitted  divergence 
between  par  and  issue  price,  it  can  only  be  maintained 
by  the  interposition  of  a  correcting  item.  Thus  if  Prop- 
erty received  (P)  is  less  than  the  Capital  Stock  (C)  the 
Balance  Sheet  may  not  properly  show  P  =  C.  There  must 
be  a  formula  P  =  C  —  D  which  can  be  expressed  with 
equal  truth  in  the  form  P  -f-  D  =  C.  The  legal  fact,  as  to- 
whether  the  unpaid  difference  is  a  sum  which  can 'be  col- 
lected, if  need  be,  from  the  shareholders,  is  of  less  signifi- 
cance to  the  accountant,  and,  indeed,  may,  with  some  show 
of  justification  be  left  undecided  by  him.  If  collectible 
it  is  an  asset  and  may  appear  as  such  in  the  Balance  Sheet. 
If  not  an  enforcible  claim,  and  that  is  the  turning  point 
in  all  the  decisions  cited  in  this  chapter,  it  is  in  the  nature 
of  a  discount,  and  its  treatment  is  equally  clear.  Possibly 
the  harassed  accountant  may  be  excused  from  attempting 
to  decide  the  legal  question  on  which  such  varying  opinions 
exist,  and  may  show  the  discount  without  seeming  to  de- 
cide whether  or  not  it  is  an  asset,  making  an  equivocal 
statement  which  is  excused  by  the  difficulty  of  the  prob- 
lem. In  a  word,  wherever  the  property  received  is  not 
fairly  equivalent  to  the  par  of  the  stock  the  difference 
should  be  clearly  shown  in  the  accounts,  and  most  clearly 


168 


MODERN   ACCOUNTING 


is  this  done  by  simply  listing  it  as  Discount  on  Stock. 
This  is  identical  with  the  method  of  treating  the  difference 
between  the  nominal  value  of  a  note  given  by  the  propri- 
etor and  the  cash  received  therefor  which,  somewhere  in 
the  accounts,  must  be  shown  clearly  as  Discount. 

To  those  at  all  familiar  with  corporation  accounts  it  is 
clear  that  unfortunately  the  discount  allowed  on  stock  is 
seldom  shown.  This  is  generally  because  of  unwillingness 
to  show  clearly  the  exact  nature  of  a  transaction  which 
is  of  doubtful  legitimacy.  While  the  transaction  itself 
is  not  altered  by  the  method  in  which  it  is  treated  in  the 
accounts,  its  legal  status  may  be  greatly  improved  by  with- 
holding from  the  accounts  any  evidence  that  the  discount 
has  been  allowed.  It  is  so  difficult  to  determine  accurately 
the  value  of  any  piece  of  property,  that  the  courts  hesitate 
to  pass  upon  its  equivalence  to  the  stock  issued  therefor. 
If  the  accounts  make  a  showing  that  full  value  has  been 
received  for  the  stock,  the  court  may  not  attempt  to  dis- 
prove the  statement.  But  the  circumstance  that  a  mislead- 
ing statement  hoodwinks  the  court,  and  thus  allows  the 
transaction  to  stand  free  from  legal  interference,  by  no 
means  indicates  that  the  failure  to  show  discount  on  stock 
issued  for  less  than  its  full  face  value  is  in  accord  with 
the  correct  principles  of  accounting. 

In  actual  practice  two  subterfuges  are  resorted  to.  As- 
suming again  a  corporation  acquiring  a  plant  worth,  all 
things  included,  $50,000  and  issuing  therefor  ..$100,000 
stock,  instead  of  showing: 


Dr. 


FORM  57. 
Balance  Sheet. 


Cr. 


Plant $50,000 

Discount  on  Stock 50,000 

$100,000 


Capital  Stock    $100,000 


$100,000 


CAPITAL   STOCK  169 

the  first  method  of  concealing  this  status  presents  the  fol- 
lowing statement: 

FORM  58. 
Dr.  Balance  Sheet.  Cr. 


Plant $100,000 


Capital  Stock $100,000 


It  is  true  that  some  writers  on  accounting  justify  such 
an  entry.  For  instance,  Keister,  whose  "  Corporation 
Accounting  "  enjoys  no  little  vogue,  says  in  discussing  a 
similar  transaction :  ' '  There  is  no  objection  to  the  above 
entry.  The  machinery  cost  $30,000,  but  it  is  entered  up  at 
its  nominal  value  of  $60,000.  It  is  not  a  speculative  re- 
source, therefore  it  matters  not  what  value  is  placed  upon 
it"  (page  71). 

To  such  a  statement  little  direct  argument  can  be  made. 
Granting  that  the  valuation  of  the  fixed  plant  does  not 
affect  the  Profit  and  Loss  account  and  so  has  no  immediate 
effect  on  dividends,  certainly  the  creditor,  the  outside  pub- 
lic, and  even  to  no  small  extent  the  stockholders  are  in- 
terested in  knowing  the  exact  state  of  affairs. 

The  other  subterfuge  resorted  to,  and  one  which  the 
same  author  says  is  proper,  is  to  include  a  purely  fictitious 
asset  to  make  up  the  difference  between  the  value  of  the 
plant  and  the  amount  of  stock.  Here  the  plant  is  correctly 
listed  at  $50,000,  but  there  appears  a  new  asset,  ex  nihilo 
fit,  frequently  called  "  Goodwill  "  or  in  Keister 's  ter- 
minology "  Franchise." 

As  has  been  already  shown  there  is  no  objection  to  in- 
cluding Goodwill  or  Franchise  in  the  assets  if  such  has 
been  purchased.  The  discussion  is  here  limited  to  the  con- 
sideration of  a  case  where  the  entire  property,  with  all  its 
rights  and  appurtenances,  is  confessedly  worth  only  $50,- 
000,  and  where  the  addition  of  the  item  Goodwill  is  clearly 


170  MODERN   ACCOUNTING 

a  subterfuge.  The  insertion  of  a  nonexistent  Goodwill, 
which  was  the  method  used  by  the  promoters  of  the  Co- 
lumbia Straw  Paper  Company,  as  well  as  the  exaggeration 
of  'the  value  of  existing  assets — the  method  pursued,  for 
instance,  by  the  United  States  Shipbuilding  Company— is 
entirely  opposed  to  the  fundamental  principle  of  truthful- 
ness in  accounting. 

An  illustration  will  emphasize  this  obvious  statement. 
Had  the  stock  been  issued  to  subscribers  who  contributed 
$50,000  gold,  no  one  would  for  a  moment  justify  a  Balance 
Sheet  which  either  multiplied  the  amount  of  gold  received 
by  two,  or  calmly  added  to  its  list  of  assets  an  utterly 
imaginary  $50,000  in  silver,  in  order  to  make  the  assets 
equal  the  nominal  capital.  But  the  "  rule  for  the  valua- 
tion of  property  is  not  different'  from  that  of  money, ' '  and 
there  is  no  reason  for  a  different  standard  of  integrity 
where  stock  is  issued  in  one  way  from  that  required  in 
another. 

It  is  not  argued  here  that  equal  exactness  can  be 
secured  in  the  two  cases.  All  that  is  discussed  is  the  book- 
ing where  the  deficiency  in  value  is  recognized  by  those 
preparing  the  accounts.  No  plea  is  made  for  a  fanciful 
•or  impossibly  high  degree  of  accuracy.  It  is  only  argued 
that  conscious  misstatement,  which  exists  all  too  often  in 
corporation  finance,  which,  indeed,  has  been  characteristic 
of  American  higher  finance,  is  an  outrage  to  the  principles 
•of  accounting. 

Justice  to  the  reader,  however,  requires  the  statement 
that  the  standard  here  urged  is  not  in  accord  with  current 
•custom,  and  is  subject  to  one  line  of  reasonable  criticism. 
"While  it  cannot  be  denied  that  the  listing  of  an  asset  at 
an  overvaluation  is  technically  "  untruthful  "  it  may  be 
claimed,  with  a  good  show  of  reason,  that  it  is  not  neces- 
sarily misleading.  It  may  even  be  urged  that  "  truthful- 
ness "  can  never  be  obtained  by  any  system  of  valuation 

11 


CAPITAL   STOCK  171 

of  such  a  property  as  a  manufacturing  plant,  and  that  any 
attempt  to  make  a  valuation  is  more  likely  to  be  mislead- 
ing than  is  the  bare  statement  that  it  cost,  not  so  much 
money,  but  so  much  Capital  Stock.  This  leaves  the  cred- 
itor or  investor  to  guide  himself,  so  that,  if  he  goes  astray, 
it  is  due  to  his  own  wandering  and  not  to  his  being  misled. 
There  is  much  force  in  this  argument  which,  indeed,  is  not 
altogether  contradictory  to  what  has  been  stated  in  these 
pages.  Such  a  scheme  of  valuation  is  even  approved  by 
Mr.  A.  Lowes  Dickinson  1  to  oppose  whose  opinion  on  ac- 
counting matters,  the  layman  must,  indeed,  be  daring.  On 
this  principle  all  property  purchased  by  stock  is  listed  at 
the  par  value  of  that  stock,  but  with  an  explanatory  state- 
ment, clearly  shown  in  the  Balance  Sheet,  that  the  assets 
thus  listed  were  obtained,  not  for  cash  but  in  exchange 
for  stock.  This  principle  is  furthermore  embodied  in  the 
present  Massachusetts  Business  Corporation  Act  and  in 
the  English  Companies  Acts. 

But  despite  the  high  authority  opposed  to  the  views 
set  forth  in  this  treatise,  the  claim  is  still  made  that  to 
reject  the  standard  of  attempted  accuracy  is  a  confession 
of  impotence,  which,  while  it  exhibits  a  commendable 
modesty  on  the  part  of  professional  accountants,  seems, 
to  the  layman,  to  do -scant  justice  to  the  ability  of  that 
profession. 

It  is  interesting  to  see  how  this  problem  in  accounting 
bears  on  the  much  discussed  question  of  stock  watering. 
The  view  generally  expressed  is  that  "  stock  watering  " — 
a  term  vague  and  as  yet  ill-defined — is  in  itself  a  fraud 
upon  investors  and  a  crime  against  the  public.  From  the 
view  point  of  accounting  the  misdeed  is  more  definitely 

1  "  If  stocks  or  bonds  are  issued  for  the  purchase  of  any  definite 
property,  it  may  be  presumed  that  the  property  is  worth  the  par  value 
thereof."  Proceedings  of  the  International  Congress  of  Public  Ac- 
countants. 1904,  p.  185. 


172  MODEKN   ACCOUNTING 

located.  The  amount  of  stock  issued  is  relatively  unim- 
portant. Such  a  transaction,  as  Vice-Chancellor  Pitney 
has  said:  "  Does  not  at  all  or  in  any  manner  increase  its 
intrinsic  or  practical  value  or  in  the  least  degree  promote 
the  real  prosperity  of  the  enterprise.  ...  Its  rental  value 
will  be  practically  the  same.  .  .  .  The  division  of  profits 
.  .  .  among  the  stockholders  will  be  on  the  same  basis, 
and  the  amount  received  by  each  stockholder  will  be  the 
same  .  .  .  and  the  market  values  will  finally  settle  down 
to  the  gauge  of  the  dividends  earned  and  declared."  (61 
Atl.  850.)  The  issue  of  excessive  stock  may  be  bad  busi- 
ness policy,  indeed  T.  L.  Greene  takes  the  ground  that 
in  the  future  it  will  come  to  be  recognized  as  such,  but  the 
watering  of  the  stock,  in  itself,  aside  from  accompanying 
complications  is  the  merest  peccadillo.  The  wrong  con- 
sists in  the  "  prevarication,"  the  positive  misstatement, 
that  among  the  assets  is  a  plant  worth  $100,000  when 
everyone  concerned  in  the  transactions  knows  it  is  worth 
only  $50,000,  or  the  untruth  that  the  company  has  ac- 
quired Goodwill  worth  $50,000  when  it  is  absolutely  inno- 
cent of  any  such  possession.  If  the  other  accounts  in  the 
Balance  Sheet  are  correct  little  concern  need  be  felt  over 
stock  watering.  Its  evil  will  be  slight,  its  correction  auto- 
matic. The  onus  of  stock  watering  is  that  it  leads  to  a 
misstatement  of  the  value  of  assets  and  the  rigid  insistence 
on  absolute  integrity  in  accounts,  .both  prevents  and  cures 
any  harm  from  large  issues  of  stock.  It  must  not  then 
be  granted  for  a  moment  that  it  "  makes  no  difference  " 
at  what  figure  a  given  asset,  speculative  or  otherwise  is 
listed.  It  makes  all  the  difference  in  the  world,  the  dif- 
ference between  truth  and  falsehood. 

The  principles  of  accounting  throw  light  also  on  the 
question  of  stock  dividends.    Assuming  the  following: 


CAPITAL   STOCK 


173 


Dr. 


FORM  59. 

Balance  Sheet. 


Cr. 


Plant,  etc $85,000 

Merchandise 12,000 

Treasury  Stock 10,000 

Cash 8,000  ' 

$115,000 


Capital  Stock $100,000 

Undivided  profits 15,000 


$115,000 


the  company  has  accumulated  profits  of  $15,000  and  is  in 
position  to  pay  a  five  per  cent,  dividend.  If  this  is  paid  in 
cash  the  balance  sheet  becomes: 


Dr. 


FORM  60. 

Balance  Sheet. 


Cr. 


Plant,  etc $85,000 

Merchandise 12,000 

Treasury  Stock 10,000 

Cash 3,500 

$110,500 


Capital  Stock $100,000 

Undivided  profits 10,500 


$110,500 


If  the  directors,  however,  think  it  unwise  to  distribute  so 
much  of  the  cash  on  hand,  they  may  declare  a  dividend 
payable,  not  in  cash,  but  in  stock,  as  indeed  they  might 
declare  one  payable  in  merchandise.  If  a  stock  dividend 
is  declared  and  paid  there  results  the  following : 


Dr. 


FORM  61. 

Balance  Sheet. 


Cr. 


Plant,  etc $85,000 

Merchandise 12,000 

Treasury  Stock 5,500 

Cash 8,000 

$110,500 


Capital  Stock $100,000 

Undivided  profits 10,500 


$110,500 


174 


MODEKN   ACCOUNTING 


Not  at  all  different  in  principle  is  it  where  there  is  no 
stock  in  the  treasury,  for  if  the  condition  had  been : 


Dr. 


FORM  62. 

Balance  Sheet. 


Cr. 


Plant,  etc $85,000 

Merchandise 12,000 

Cash 18,000 

$115,000 


Capital  Stock $100,000 

Undivided  profits 15,000 


$115,000 


new  stock  could  have  been  issued  (provided  the  company 
had  power  to  increase  its  capital  stock)  with  which  to  pay 
the  dividend.  In  the  latter  case  the  final  Balance  Sheet 
would  show: 


Dr. 


FORM  63. 
Balance  Sheet. 


Cr. 


Plant,  etc $85,000 

Merchandise 12,000 

Cash 18,000 

$115,000 


Capital  Stock $105,000 

Undivided  profits 10,000 


$115,000 


The  only  difference  in  the  two  cases  is  that  in  one  stock 
already  held  in  the  treasury  is  decreased,  in  the  other 
Capital  Stock  outstanding  is  increased. 

However  objectionable  such  a  transaction  may  be  con- 
sidered in  its  effect  on  the  public,  or  however  much  it  may 
be  prohibited  by  particular  statutes  of  individual  states, 
it  is,  to  the  accountant  a  perfectly  simple  and,  indeed, 
from  his  view  point  a  perfectly  legitimate  transaction. 
New  stock  is  indeed  issued  without  the  receipt  of  addi- 
tional wealth,  but  the  wealth  has  previously  been  received 
by  the  corporation,  as  is  shown  by  the  credit  to  Undi- 
vided Profits.  The  cancelation  of  $5,000  undivided  profits 


CAPITAL   STOCK  175 

against  $5,000  stock  is  a  full  payment  therefor,  so  far  as 
accounting  is  concerned.  « 

This  is  clearly  brought  out  in  "Williams  v.  Western 
Union  Telegraph  Company,  where  the  point  at  issue  was 
whether  a  stock  dividend  was  legitimate  when  the  com- 
pany had  a  large  accumulated  surplus.  The  court  said: 

"  We  know  of  no  law  that  is  violated  and  no  public 
policy  that  is  invaded  by  issuing  to  the  stockholders  stock 
to  represent  that  amount  of  property  rather  than  in  any 
mode  to  divide  it  up  and  distribute  it  among  them.  If  it 
can  issue  stock  in  payment  of  property  to  be  obtained  by 
it  as  part  of  its  capital  for  its  legitimate  uses,  why  may  it 
not  issue  stock  in  payment  for  property  in  effect  pur- 
chased of  them  and  added  to  its  permanent  capital  and 
which  they  relinquish  the  right  to  have  divided?  So  long 
as  every  dollar  of  stock  issued  by  a  corporation  is  repre- 
sented by  a  dollar  of  property,  no  harm  can  result  to  in- 
dividuals or  the  public  from  distributing  the  stock  to  the 
stockholders."  (93  N.  Y.  190.) 

The  difficulty  which  the  accountant  cannot  overcome 
is  when  he  is  asked  to  book  a  stock  dividend  where  no 
profits  have  been  earned,  a  transaction  which  unfortu- 
nately sometimes  occurs.  Had  the  Balance  Sheet  given 
above  showed  no  Undivided  Profits,  the  payment  of  a  divi- 
dend of  any  sort,  whether  in  stock,  or  cash,  would  be 
equally  objectionable,  for  a  dividend  implies  profits  to  be 
divided.  Were  either  cash  or  stock  to  be  distributed  as  a 
dividend,  in  the  absence  of  accumulated  profits,  a  correct 
accounting  would  require  the  showing  of  a  deficit  due  to 
the  payment  of  the  dividend.  But  this,  showing  at  once 
the  illegality  of  the  dividend,  is  not  satisfactory  to  the 
directors  guilty  of  such  action.  The  only  way  to  hide  the 
unlawful  act  is  to  introduce  into  the  accounts  some  fic- 
titious asset,  creating  thereby  a  correspondingly  unreal 
profit,  which,  once  created,  can  in  turn  be  canceled  against 


176 


MODERN   ACCOUNTING 


either  cash  or  stock  paid  out  in  dividends.  It  is  to  be 
noted,  however,  that  the  jsvrong  accounting  here  consists  in 
the  preliminary  creation  of  fictitious  profits,  by  falsely 
marking  up  the  value  of  the  assets,  and  not  in  the  stock 
dividend  as  such.  A  dividend,  whether  in  cash,  merchan- 
dise, real  estate,  or  stock  is,  in  the  absence  of  statutory 
prohibition,  legitimate  whenever  real  profits  exist,  and 
only  when  they  so  exist.  But  such  profits  failing,  a  cash 
dividend  is  just  as  objectionable  as  one  in  stock ;  in  fact  it 
is  more  so,  as  the  paying  out  of  cash  may  damage  existing 
creditors,  the  issuing  of  stock  cannot. 

A  transaction,  unusual  in  character  but  not  infre- 
quently occurring,  is  where  some  of  the  outstanding  stock 
is  donated  to  the  company  by  its  original  holders.  The 
stock  thus  received  is  ordinarily  sold  for  the  purpose  of 
raising  cash  for  the  use  of  the  company,  the  selling  price 
generally  being  below  par,  as  the  stock,  having  previously 
been  issued  as  full  paid  stock,  carries  with  it  no  liability 
to  subsequent  purchasers  at  a  lower  price. 

Thus,  to  cite  as  illustration  an  actual  case,  a  company 
gave  its  entire  capital  stock,  $300,000  in  purchase  of  prop- 
erty, the  vendors  agreeing  to  donate  $40,000  of  the  stock 
to  the  company.  Assuming  that  the  property  purchased 
was  actually  worth  $300,000— in  this  particular  case  a 
false  supposition — the  accounts  should  show: 


Dr. 


FORM  64. 
Balance  Sheet. 


Cr. 


Property $300,000 

Treasury  Stock 40,000 


$340,000 


Capital  Stock $300,000 

Surplus    from     donated 

stock 40,000 

$340,000 


The  company  was  then  in  a  position  to  sell  its  stock  at  the 
market  price  and  thus  raise  money  for  working  capital. 


CAPITAL   STOCK  177 

If  sold  at  less  than  par  the  discount  could  be  charged 
against  the  surplus,  the  balance  of  which  should  show  the 
actual  amount  received  when  the  stock  is  all  sold. 

The  donation  of  wealth  is  so  unusual  a  business  trans- 
action that  by  some  critics  it  is  always  considered  tainted. 
But  it  is  at  least  conceivable  that  it  may  be  perfectly  legit- 
imate. Granting  that  the  property  is  really  worth  $300,- 
000,  it  may  nevertheless  be  difficult  to  persuade  outside 
capitalists  of  that  fact,  and  the  organizers  of  the  corpora- 
tion have  no  ready  money  with  which  to  exploit  the  prop- 
erty. In  order  to  secure  the  success  of  the  enterprise  the 
vendors,  confident  of  the  ultimate  success,  may  be  willing 
to  make  the  sacrifice  in  order  to  get  it  started,  just  as  an 
inventor  may  sell  a  half  interest  in  a  patent  at  a  price 
which  he  is  perfectly  confident  is  far  below  the  capitalized 
value  of  the  anticipated  earnings. 

While  it  is  possible  then  to  conceive  of  such  a  trans- 
action as  being  just  what  it  pretends  to  be,  it  is  perhaps 
not  extravagant  to  claim  with  Schuster  that  "  generous 
benefactors,  who  give  away  their  savings  to  trading  com- 
panies are  freaks  of  nature  who  need  not  trouble  che 
legislator's  [or  the  accountant's]  mind."  In  many  cases, 
probably  in  the  great  majority  of  cases,  the  transaction 
thus  described  is  the  barest  subterfuge  to  enable  the  com- 
pany to  sell  its  stock  below  par  free  from  liability.  In  the 
case  cited  the  vendors  were  really  selling  their  property 
for  $260,000  in  stock,  and  the  company  was  placing  $40,- 
000  of  its  stock  on  the  market  to  raise  working  capital. 
But  to  have  sold  such  stock  below  par  would  have  involved 
obligation  on  the  part  of  the  purchaser  to  make  up  the 
difference,  and  so  there  was  a  resort  to  a  subterfuge  both 
stupid  and  palpable.  Here  again  the  error  from  the  ac- 
counting view  goes  back  to  the  first  entry,  namely,  the 
statement  that  the  property  acquired  was  worth  $300,000, 
when  in  fact  it  was  clearly  worth  not  over  $260,000.  Like 


178 


MODERN   ACCOUNTING 


all  other  cases  of  overissue  of  stock  the  culpable  element, 
at  least  from  the  accountant's  view  point,  is  in  the  mis- 
statement  of  facts  regarding  the  valuation  of  the  assets 
acquired.  That  being  correctly  given  no  real  problem  can 
arise.  For  if  the  Balance  Sheet  had  correctly  shown  the 
status  as  follows: 


Dr. 


FORM  65. 
Balance  Sheet. 


Cr. 


Property $260,000 

Discount  on  Stock 40,000 

$300,000 


Capital  Stock $300,000 


$300,000 


even  though  the  discount  were  treated  as  something  which 
could  not  be  collected,  there  need  be  no  misleading  of  the 
public  and  the  donation  of  the  stock  could  not  hide  the 
fact  of  the  discount  on  the  later  sale. 

By  some  rigid  accountants,  among  whom  are  Seymour 
Walton  and  most  German  writers,  the  donation  of  part  of 
the  stock  by  vendors  is  to  be  construed  inevitably  as  a  de- 
duction to  be  made  from  the  nominal  purchase  price  of 
the  property.  But  no  such  severe  standard  has  been  set 
by  the.  courts.  It  is  true  that  in  an  earlier  New  York 
case  it  was  held  that  such  a  contribution  was  at  least  cor- 
roborative evidence  of  overvaluation  (Douglass  v.  Ireland, 
73,  N.  Y.  100.  (1898) ).  But  the  more  recent  English  case 
of  Innes  &  Company  ([1903]  2  Ch.  254)  takes  a  differ- 
ent view;  and  the  Colorado  case  of  Speer  v,  Bordeleau 
(79  Pac.  332.  (1905))  distinctly  states  that  such  a  transac- 
tion is  not  evidence  of  issue  below  par.  But  whether  the 
presumption  is  in  favor  of  valuing  the  property  at  the 
amount  of  stock  originally  given  the  vendors,  or  at  the  net 
amount  retained  by  them,  if  it  is  established  that  the  for- 
mer figure  wculd  be  an  actual  overvaluation,  there  is  no 


CAPITAL   STOCK  179 

excuse  for  such  an  incorrect  representation  in  the  accounts. 
The  accountant  should  transcend  the  limitations  under 
which  the  courts  labor. 

The  donation  of  stock  has  a  further  purpose,  one  which 
might  be  otherwise  obtained,  of  providing  a  fund  which 
can  be  used  in  covering  the  organization  expenses,  or  those 
which  may  be  incurred  during  the  early  years  of  the  cor- 
poration. The  securing  of  such  a  fund  is  a  perfectly  legit- 
imate, indeed  a  praiseworthy,  procedure.  The  contribu- 
tion of  stock  is  no  more  unreasonable,  and  has  exactly  the 
same  effect  as  the  sale  of  the  stock  at  a  premium  for  the 
same  purpose  of  providing  a  fund  for  initial  expenses.  As 
these  are  incurred  they  can  be  charged  against  the  Sur- 
plus, wrhich  thus  gradually  disappears.  The  process  is 
identical  wrhether  the  Surplus  is  raised  by  the  contribution 
of  stock,  or  by  the  practical  contribution  of  cash  under  the 
name  of  premium  on  stock. 

Some  question  may  be  raised  as  to  the  nomenclature 
used  in  the  transaction  just  discussed.  In  the  Balance 
Sheet  in  Form  64  a  descriptive  title  "  Surplus  from  do- 
nated stock  "  is  used,  and  that  is  incontrovertibly  correct, 
although  it  may  well  be  that  a  less  cumbrous  term  would 
serve  in  its  place.  Some  writers  have  employed  the  term 
"  Working  Capital  "  for  the  credit  item.  This  innova- 
tion is  of  doubtful  propriety,  for  "  Working  Capital  "  has 
long  had  a  specific  meaning  as  a  collective  term  for  what 
are  often  called  ' '  quick  assets, ' '  e.  g.,  cash,  accounts  re- 
ceivable, perhaps  merchandise,  etc.  The  new  use  of  the 
term  has  some  vogue  in  America,  but  it  is  not  found  in 
England,  nor  does  it  conform  to  the  use  of  the  term  in 
legal  definitions,  nor  even  to  the  more  established  and  bet- 
ter recognized  accounting  practice  in  this  country. 

The  most  important  stock  transactions,  of  recent  years 
have  been  those  of  the  so-called  trusts,  where  the  stock 
of  the  new  company  is  issued  largely  to  acquire  the  busi- 
19 


180 


MODERN   ACCOUNTING 


ness  and  plants  of  established  competing  firms  or  corpora- 
tions. There  are  two  forms  in  which  this  may  be  done, 
omitting  the  case  where  the  stock  is  issued  to  purchasers 
for  cash  and  the  subsidiary  plants  purchased  with  the 
funds  thus  received.  The  stock  of  the  consolidating  com- 
pany may  either  be  given  to  the  stockholders  of  the  old 
company  as  individuals,  in  exchange  for  their  holdings; 
or  the  new  stock  may  be  used  to  purchase  the  plants,  good- 
will, etc.,  from  the  subordinate  companies.  In  extreme 
and  simple  form  this  may  be  illustrated  by  the  case  of 
Corporation  A  organized  with  $1,500,000  capital  stock 
which  is  used  to  make  a  combination  of  Corporations  B 
and  C,  whose  Balance  Sheets  are  respectively: 


Dr. 


FORM  66. 
Balance  Sheet  of  B. 


Cr. 


Plant  and  other  assets.. .  $600,000 


$600,000 


Capital  Stock $300,000 

Surplus 300,000 

$600,000 


Dr. 


FORM  67. 
Balance  Sheet  of  C. 


Cr. 


Plant  and  other  assets. . .  $300,000 


Capital  Stock $300,000 


The  agreement  made  is  that  three  shares  of  stock  of  Cor- 
poration A  shall  be  given  in  exchange  for  each  share  of 
stock  in  B,  that  $400,000  stock  shall  be  given  for  the 
plant,  goodwill  and  other  assets  of  C,  and  that  the  re- 
maining stock  of  A  is  to  be  issued  to  subscribers  for  cash 
at  par. 

Assuming  that  the  bargain  is   an  equitable   one   all 


CAPITAL   STOCK 


181 


around,  the  Balance  Sheets  of  the  three  corporations,  after 
the  transactions,  will  be : 


Dr. 


FORM  68. 
Balance  Sheet  of  A. 


Cr. 


Stock  of  Corporation  B 

3,000  shares  at  $300. . .  $900,000 

Plant,  etc 300,000 

Goodwill  at  cost 100,000 

Cash.: 200,000 

$1,500,000 


Capital  Stock $1,500,000 


Dr. 


FORM  69. 
Balance  Sheet  of  B. 


$1,500,000 


Cr 


Plant  and  other  assets. . .  $600,000 


$600,000 


Capital  Stock $300,000 

Surplus 300,000 

$600,000 


Dr. 


FORM  70. 
Balance  Sheet  of  C. 


Cr. 


Stock  of  Company  A 

4,000  shares  at  $100.. .  $400,000 

$400,000 


Capital  Stock $300,000 

Surplus 100,000 

$400,000 


The  Balance  Sheet  of  B  is  of  course  unchanged  as  the 
transaction  was  between  A  and  the  individual  stockholders. 
The  Balance  Sheet  of  C  shows  stock  of  A  held  as  its  only 
asset.  Reniembering  the  assumption  made  above  that  the 
consolidation  is  equitable,  which  implies  that  full  par  value 
is  given  and  received,  C  must  show  a  Surplus  (Profit)  of 
$100,000.  A  shows  the  stock  of  B  bought  of  the  share- 
holders, but  not  the  assets  of  B  which  still  belong  to  that 
corporation,  the  only  change  being  a  shifting  in  the  per- 


182  MODERN   ACCOUNTING 

sonnel  of  the  stockholders.  But  it  shows  not  only  the 
former  assets  of  C,  but  also  the  Goodwill  which  it  bought 
from  C,  which  was  not  included  in  the  assets  of  C,  but 
which  is  legitimately  included  in  those  of  A. 

It  is  furthermore  clear  that  the  stock  of  A  might  have 
been  issued  at  a  premium,  and  that  any  possible  varia- 
tions in  terms  and  prices  could  occur  without  affecting 
the  principles  elucidated  in  this  most  simple  illustration. 
As  to  the  legality  of  the  combination  under  statute  law 
the  present  discussion  is  not  concerned,  but  providing  a 
consolidation  takes  place  in  the  manner  specified,  the  ac- 
counting should  be  as  above. 

It  may  be  that  the  holding  corporation  prefers  to  show 
in  its  Balance  Sheet  not  the  stock  of  B  but  the  detailed 
assets,  a  plan  in  part  adopted  by  the  United  States  Steel 
Corporation.  While  such  a  showing  is  desirable  for  cer- 
tain purposes,  formally  and  legally  A  does  not  own  the 
assets  of  B  so  long  as  B  retains  its  legal  corporate  exist- 
ence. If  the  merger  works  a  dissolution  of  B  the  case  is 
otherwise. 


BIBLIOGRAPHICAL  NOTE  TO  CHAPTERS  VIII  AND  IX. 

On  the  technical  bookkeeping  entries  to  be  made : 
BENTLEY,  H.  C.     Corporation  Finance  and  Accounting.     Chapter 

VII.    New  York,  1908. 
CAHNES,  A.  J.     Manual  on  Opening  and  Closing  the  Books  of  Joint 

Stock  Companies.     Third  edition.     Baltimore,  1891. 
KEISTER,  D.  A.     Corporation  Accounting  and  Auditing.     Eleventh 

edition.     Cleveland,  1905. 
RAHILL,   J.   J.     Corporation  Accounting  and   Corporation   Law. 

Fresno,  1906. 

For  a  more  serious  discussion  of  the  principles  involved  see : 
CHARPENTIER,  J.     Etude  juridique  sur  le  bilan  dans  les  socie"te*s 
par  actions,  pp.  42-81.     Paris,  1906. 


CAPITAL   STOCK  183 

REHM,  H.     Die  Bilanzen,  p.  342-477.     Munich,  1903. 
SIMON,  H.  V.     Die  Bilanzen  der  Aktiengesellschaften,  p.  201-227. 
3  Aufl.     Berlin,  1899. 

For  a  discussion  of  the  laws  relating  to  issue  of  capital  stock : 

CLARK,  W.  L.  and  MARSHALL,  W.  L.  A  Treatise  on  the  Law  of 
Private  Corporations,  §§  389-401.  St.  Paul,  1901. 

COOK,  W.  W.  A  Treatise  on  the  Law  of  Corporations  having  a 
Capital  Stock.  Chapter  II.  Methods  of  Issuing  Stock.  Chap- 
ter III.  Watered  Stock.  Fifth  edition.  Chicago,  1903. 

HUFFCUT,  E.  W.  Selling  New  Shares  at  Less  than  Par.  American 
Law  Review,  XXVI,  p.  861.  [Discusses  Handley  v.  Stutz 
and  Ooregum  Co.  v.  Roper.] 

PALMER,  F.  B.     Company  Law.     Fourth  edition.     London,  1902. 


CHAPTER   X 

LIABILITIES 

As  was  shown  in  Chapter  III  the  credit  side  of  the 
Balance  Sheet  is  frequently  headed  "  Capital  and  Liabili- 
ties." This  is  a  comprehensive  title,  for  in  the  approved 
form  of  the  Balance  Sheet  the  mere  valuation  accounts 
— such  as  Depreciation  Account— being  subtracted  from 
the  nominal  assets  there  remains  on  the  credit  side  only 
Capital— including  all  unrepresented  capital,  such  as 
Surplus,  Reserves,  and  Undivided  Profits — and  the  out- 
side liabilities  of  the  concern.  In  a  limited  sense,  it  is 
true,  liabilities  are  also  a  subtrahend  from  the  assets, 
for  a  debt,  as  shown  in  Chapter  I,  is  really  a  negative 
asset.  But  to  show  only  the  net  excess  of  assets  over  lia- 
bilities, or  of  some  one  asset  over  the  particular  liability 
which  it  secures  (as,  for  instance,  to  show  only  the  equity 
in  a  piece  of  real  estate,  instead  of  showing  both  the  value 
of  the  property  and  the  mortgage  on  it)  is  universally  rec- 
ognized as  incorrect  and  misleading.  Ah  exception  is 
found  in  the  Double-Account  Balance  Sheets  used  by  cer> 
tain  English  companies.  There,  in  the  Balance  Sheet 
proper  is  shown  only  the  excess  of  assets  over  the  sum  of 
capital  and  funded  debt.  But  this  exception  is  formal 
rather  than  real,  for  the  accompanying  Capital  Account 
clearly  exhibits  the  full  status.  The  same  principle  is 
applied  occasionally  in  American  accounting,  as,  for  in- 
stance, in  a  modified  form,  in  the  Balance  Sheet  of  the 
Atchison,  Topeka,  and  Santa  Fe  Railway  Company. 
Somewhat  similarly  the  Illinois  Central  shows  in  the  Bal- 

1&4 


LIABILITIES 


185 


*nce  Sheet  only  the  excess  of  the  current  assets  over  the 
current  liabilities.  But  there  is  a  reference  given  to  a  de- 
tailed exhibit  on  another  page  where  the  full  information 
is  to  be  found. 

Rehm  goes  further  and  suggests  that  the  proper  form 
of  a  Balance  Sheet,  from  the  economic  view  point,  is  one 
in  which  negative  items  are  shown  as  subtractions,  prac- 
tically as  follows: 


Assets. 


FORM  71. 

Balance  Sheet. 


Liabilities. 


Plant,  etc $610,000 

Other  assets..      50,000 


$660,000 
Less  Debts 40,000 


$620,000 


Capital  Liabilities: 

Capital  Stock $600,000 

Reserve  Funds 10,000 

610,000 
Profits: 

Excess   of  in- 
come  $12,000 

Depreciation. .      2,000 


10,000 
$620,000 


While  from  a  theoretical  point  of  view  debts  are  nega^ 
tive  assets,  and  differ  radically  from  capital,  it  is  well-nigh 
universal  to  list  both  capital  and  liabilities  on  the  same 
side  of  the  Balance  Sheet,  and  no  criticism  is  ordinarily 
made  of  this  practice.  All  that  is  necessary  is  clearly  to 
differentiate  the  two,  and  to  be  sure  that  there  is  no  un- 
derstatement of  the  amount  of  liabilities. 

The  accounting  problems  having  to  do  with  liabilities 
are  extremely  simple  as'  compared  with  those  relating  to 
assets.  This  is  principally  due  to  the  fact  that  the  ques- 
tion of  valuation,  so  perplexing  in  regard  to  assets,  prac 
tically  disappears  when  liabilities  are  concerned.  One 
may  suffer,  indeed  one  must  expect,  some  diminishment 
in  the  value  of  assets  but  debts,  so  long  as  the  principle 


186  MODERN  ACCOUNTING 

of  the  going  concern  is  recognized,  must  be  shown  at  their 
full  amount.  The  only  problems  which  arise  in  the  book- 
ing of  liabilities  are  those  which  group  around  the  clas- 
sification of  liabilities,  the  calculation  of  interest,  the 
treatment  of  unissued,  repurchased,  and  canceled  debts, 
and  a  few  questions  in  which  there  may  arise  a  doubt 
whether  there  is  an  existing  liability  or  not.  These  will 
be  considered  in  order. 

The  clearness  and  consequent  value  or  the  Balance 
Sheet  is  increased  if  some  classification  is  made  of  the 
various  kinds  of  debt.  Thus  a  showing  of  the  funded  or 
long  time  debt  separate  from  the  short  time  or  floating 
debt  is  of  great  importance,  indicating,  as  it  does,  the  im- 
mediate financial  strength  of  the  concern,  and  whether  or 
not  it  is  likely  to  suffer  loss  because  subject  to  a  sudden 
demand  from  its  creditors.  The  distinction  between  debts 
for  which  notes  or  acceptances  have  been  given  and  open 
book  accounts  is  also  important.  The  extent  to  which  such 
classification  is  to  be  carried,  as  in  the  corresponding  clas- 
sification of  assets,  is  a  matter  of  discretion,  governed  by 
individual  circumstances.  The  statements  rendered  by  the 
National  Banks  to  the  Comptroller  five  times  yearly  con- 
tain seven  different  subdivisions  of  liabilities  to  depositors. 
One  of  these  same  banks  will  give,  in  the  condensed  Bal- 
ance Sheet  published  for  advertising  purposes,  only  the 
single  item  Deposits.  Both  of  these  statements  are  correct ; 
each,  for  its  purpose,  is  full  as  well  as  fair.  But  what- 
ever subdivisions  are  made,  the  classification  adopted  must 
be  strictly  observed.  It  may  be  perfectly  correct  to  include* 
all  liabilities  to  depositors  under  the  one  head  ' '  Due  to  de- 
positors. ' '  But  where  a  subdivision  is  made  it  is  incorrect 
and  fraudulent  to  list  under  the  title  "Accounts  payable  " 
items  which  really  are  "  Bills  payable  "  or  to  include 
either  of  these  items  under  the  title  "  Funded  Debt." 

The  questions  which  relate  to  the  calculation  of  inter- 


LIABILITIES  187 

est  on  debts  are  the  most  interesting  which  arise  in  regard 
to  the  accounting  of  liabilities.  As  a  matter  of  conven- 
ience debts,  whether  receivable  or  payable,  are  ordinarily 
listed  in  books  at  their  face  value  rather  than  at  their 
real  value.  Where  the  note  is  discounted,  it  follows  that 
there  must  be  a  counter  entry  to  a  Discount  account. 
"Where  the  note,  or  other  obligation  is  not  discounted,  but 
bears  interest  from  date,  the  adjustment  is  not  made  until 
some  later  date.  When  a  formal  Balance  Sheet  is  pre- 
pared it  is  accordingly  necessary,  in  order  to  make  a  cor- 
rect showing  of  the  liabilities  of  the  concern,  to  make  an 
exact  reckoning  of  interest  on  outstanding  liabilities.  This 
is  exhibited  in  the  Balance  Sheet,  either  as  a  liability 
"  Interest  accrued,"  which  for  convenience  may  be  added 
to  the  face  of  the  debt,  or,  in  case  the  note  was  discounted 
in  advance,  as  a  deferred  asset,  perhaps  under  the  title 
"  Discount  paid  in  advance." 

Such  an  estimate  is  very  simply  made  in  case  of  short 
time  obligations.  When  bonds  are  emitted  the  calculation 
is  more  complicated,  and  the  treatment  in  the  accounts  is 
not  uniform.  The  estimation  of  simple  interest  accrued 
on  the  bonds  since  the  time  the  last  interest  payment  was 
made  is  of  course  identical  with  the  calculation  of  interest 
on  a  short  note,  and  no  divergence  of  practice  occurs  :u 
that  regard.  The  main  point  of  difficulty  is  in  regard  to 
the  premium  or  discount  allowed  on  the  bonds  at  the  time 
of  issue.  As  shown  in  discussing  investments,  the  pre- 
mium paid  on  a  bond  is  virtually  the  price  paid  for  the 
privilege  of  receiving  nominal  interest  at  a  rate  higher 
than  the  market  rate.  Viewing  the  transaction  from  the 
borrower's  point  of  view,  the  premium  received  is,  there- 
fore, a  lump  payment  made  in  return  for  the  obligation 
to  pay  an  excessive  rate  of  interest  during  the  life  of  the 
bond.  If  the  credit  of  the  company  and  the  conditions 
of  the  market  would  have  enabled  the  company  to  issue 


188  MODERN  ACCOUNTING 

a  five  per  cent,  twenty-year  bond 'at  par,  its  six  per  cent, 
bond,  running  the  same  time,  should  sell  at  approximately 
112.46.  This  premium  of  12.46  is,  therefore,  the  present 
value  of  the  annuity  of  one  per  cent,  which  the  company 
must  pay  for  twenty  years.  But  the  interest  installments 
as  paid  are  normally  and  properly  charged  as  an  expense, 
and  consequently  the  12.46  per  cent,  should  be  spread  over 
all  the  years  during  which  the  interest  is  thus  paid,  in 
order  properly  to  equalize  the  profits  of  the  several  years. 
The  correct  entry,  therefore,  is  to  credit  the  premium  re- 
ceived to  "  Premium  on  bonds  issued  "  a  part  of  which 
is  annually  written  off  to  offset  the  interest  paid  the  bond 
holders.  It  might,  however,  all  be  placed  in  some  Reserve, 
and  this  is  not  infrequently  done.  This,  while  theoret- 
ically incorrect,  is  condoned  by  many  authorities  on  the 
ground  that  it  leans  to  conservatism.  The  opposite  treat- 
ment of  crediting  the  premium  at  once  to  Profit  and  Loss 
is  manifestly  incorrect,  for  the  premium  is  in  no  sense 
profit  and  least  of  all  profit  of  the  single  year  in  which  it 
is  received.  The  apportionment  of  premium  between  the 
years  is  most  scientifically  done  on  the  basis  of  the  declin- 
ing value  of  the  annuity  which  it  represents,  according  to 
the  method  described  in  discussing  the  valuation  of  invest- 
ments. 

Exactly  the  same  principle  applies  to  bonds  issued  at 
a  discount,  just  as  the  same  principle  applies  to  bonds 
bought  below  par.  The  discount  should  appear  at  first 
among  the  assets,  but  should  gradually  be  written  off  as 
the  years  pass,  thus  making  the  annual  charge  to  interest 
correspond  to  the  real  rather  than  the  nominal  rate  paid. 
This  practice  is  frequently  met  with  as,  for  instance,  in 
the  accounts  of  the  Lackawanna  Steel  Company,  and  the 
Chicago  and  Alton  Railway.  At  times  the  annual  charge 
is  based  on  the  actuarial  estimate  of  the  value  of  the  an- 
nuity, at  times  merely  divided  into  equal  annual  charges, 


LIABILITIES  189 

at  times,  still  less  scientifically,  but  even  more  conserva- 
tively charged  off  much  more  rapidly,  or  even  all  charged 
off  to  expense  in  the  first  year. 

Among  American  Railways,  however,  the  custom  is  to 
charge  discount  on  bonds  to  the  construction  account. 
The  temptation  to  do  this  is  great,  as  in  the  early  years  of 
a  railroad's  life  the  burdening  of  the  income  account  with 
any  additional  charges  is,  of  course,  unpleasant.  But  curi- 
ously enough  this  practice  is  justified  by  many  writers, 
among  whom  may  be  mentioned  T.  L.  Greene  and  Rehm. 
Greene  makes  the  statement  absolutely,  as  applying  to  all 
discount  on  bonds  issued.  Rehm  more  cautiously  applies 
it  only  to  the  discount  on  bonds  whose  nominal  rate  is 
equal  to  the  current  market  rate,  or  to  that  part  of  the 
discount  which  represents  a  rate  higher  than  the  market. 
The  argument  in  favor  of  this  is  that  the  discount  repre- 
sents, at  least  in  so  far  as  it  makes  the  actual  rate  paid 
higher  than  the  current  market  rate,  an  additional  cost 
of  the  road,  a  cost  due  to  the  lack  of  credit.  Thus  if  five 
per  cent,  is  deemed  the  normal  rate,  the  discount  on  a  four 
per  cent,  bond  necessary  to  make  it  net  five  per  cent,  repre- 
sents interest;  but  discount  on  a  five  per  cent,  bond,  or 
discount  on  the  four  per  cent,  bond  in  excess  of  12.46, 
represents  not  interest,  but  the  cost  due  to  poor  credit. 

But  such  a  differentiation  is  extremely  difficult  to  ap- 
ply. All  that  one  can  confidently  assert,  in  the  case  as- 
sumed, is  that  the  market  rate  for  a  twenty-year  bond  of 
this  particular  company  is  five  per  cent.,  while  the  nominal 
rate  was  made  four  per  cent.  Furthermore,  the  charging 
of  discount  to  construction  results,  in  the  absurdity  of 
making  the  road  cost  more  the  longer  the  bonds  have  to 
run.  In  the  case  mentioned  for  each  million  dollars  re- 
ceived from  bonds  and  expended  on  construction  there 
would  need  to  be  added  some  $140,000  for  discount,  but 
had  similar  bonds  running  fifty  years  been  issued,  for  each 


190  MODERN   ACCOUNTING 

million  thus  provided  there  must  be  added  approximately 
$220,000. 

To  be  consistent,  those  who  argue  that  discount  due  to 
deficient  credit  is  part  of  the  cost  of  construction  should 
go  further  and  increase  the  cost  annually  whenever  the 
company  pays  more  than  the  normal  rate.  The  company 
whose  poor  credit  forces  it  to  pay  11.47  per  cent,  discount 
on  a  five  per  cent,  bond,  could  have  sold  a  six  per  cent, 
bond  at  par.  But  this  would  necessitate  an  annual  pay- 
ment of  one  per  cent,  additional  interest  above  the  normal 
market  rate.  Why  should  not  this  annual  payment  be 
charged  to  cost  of  construction  if  the  equivalent  and  alter- 
native payment  of  11.47  per  cent,  once  for  all  is  thus  to 
be  charged?  Yet  no  one  of  those  writers  who  attempt  to 
differentiate  between  discount  due  to  a  subnormal  nominal 
rate,  and  discount  due  to  deficient  credit,  advocates  such 
a  practice.  The  Interstate  Commerce  Commission  at- 
tempts'the  difficult  distinction  between  discount  on  securi- 
ties and  commissions  on  their  sale.  The  former  is  held 
not  to  be  properly  included  in  the  cost  of  property,  the 
latter  may  be. 

Occasionally  bonds  are  issued  repayable  at  a  premium. 
Where  such  repayment  is  optional  on  the  part  of  the  bor- 
rower the  provision  for  the  premium  is  in  the  nature  of 
a  special  reserve.  If,  however,  the  repayment  at  the  pre- 
mium is  accepted  as  part  of  the  financial  policy  of  the 
concern,  the  premium  as  well  as  the  par  value  of  the  bonds 
becomes  an  obligation  and  should  appear  in  the  Balance 
Sheet.  The  two  elements  may,  however,  be  kept  separate. 
Where  bonds  thus  redeemable  at  a  premium  are  sold  at  a 
price  other  than  the  redemption  figure,  the  difference  be- 
tween the  two  should  be  treated  just  as  premium  or  dis- 
count on  bonds  redeemable  at  par  are  treated. 

The  treatment  of  bonds  authorized  but  not  yet  issued 
is  not  different  in  principle  from  that  of  unissued  stock, 


LIABILITIES  191 

already  discussed.  Any  one  of  the  alternative  forms  given 
on  page  148  may  be  applied  to  such  bonds.  But,  as  in  the 
case  of  stock,  if  the  unissued  bonds  appear  in  the  Balance 
Sheet  among  the  assets,  the  nature  of  such  holdings  must 
be  clearly  shown.  It  is  illegitimate  to  include  them  with 
outside  investments  under  a  general  heading,  "  Invest- 
ments," or  "  Bonds  and  Stocks."  Where  the  unissued 
bonds  are  secured  by  a  lien  on  specific  property  there  is 
additional  justification  in  including  them  among  the  as- 
sets rather  than  in  merely  deducting  them  from  the  out- 
standing debts.  The  property  pledged  to  secure  the  bonds 
gives  them  a  somewhat  independent  value,  and  makes  them 
perhaps  an  available  asset  even  in  the  case  where  the  com- 
pany is  in  a  poor  financial  condition. 

Furthermore,  bonds,  unlike  stock,  may,  in  the  absence 
of  special  legislation,  be  freely  issued  below  par.  Hence 
it  is  not  important  to  distinguish  in  the  case  of  bonds,  as 
it  is  in  the  case  of  stock,  between  those  which  are  unissued 
and  those  which  have  been  reacquired. 

But  in  any  case  the  most  complete  and  hence  the  most 
satisfactory  way  of  presenting  all  the  facts  is  to  exhibit 
the  unissued  bonds  on  both  sides  of  the  Balance  Sheet. 
This  treatment  is  found,  for  instance,  in  the  Balance 
Sheets  of  the  Chicago  and  Northwestern  Railway,  and  may 
be  simply  illustrated  as  follows: 

FORM  72. 
Dr.  Balance  Sheet.  Cr. 


Miscellaneous  Assets 
Bonds  of  Company  held 

in  Treasury $50,000 

etc.,  etc. 


Bonded  Debt 

Outstanding  $100,000 
Held    in 


The  treatment  of  bonds  purchased  in  the  market  is  sim- 
ilar to  that  of  stock  thus  purchased  and  held  in  the  treas- 


192  MODERN   ACCOUNTING 

ury.  The  purchased  bonds  may,  however,  at  any  time  be 
canceled  and  the  outstanding  debt  thus '  reduced  without 
any  further  formality,  while  the  purchase  of  its  own  stock 
by  a  company  does  not  in  itself  work  a  reduction  of  the 
nominal  capital,  to  accomplish  which  certain  legal  pro- 
cedures must  be  followed.  A  distinction  should  be  made 
between  a  bond  redeemed,  especially  where  it  is  formally 
canceled,  and  one  merely  bought  on  the  open  market  and 
held  in  the  treasury  as  a  live  bond.  Where  the  former 
takes  place  it  must  disappear  entirely  from  the  Balance 
Sheet. 

The  showing  of  contingent  liabilities,  that  is  of  liabili- 
ties for  which  the  proprietor  may  be  held  under  certain 
contingencies  but  which  he  never  expects  to  have  to  meet, 
is  a  perplexing  problem.  An  illustration  is  where  a  manu- 
facturer sells  machinery  with  a  guaranty.  Ordinarily 
such  an  obligation  to  indemnify  the  purchaser  in  case  the 
machinery  fails  to  render  proper  service  does  not  show 
in  the  books  at  all,  and  yet  it  may  constitute  an  important 
fact  in  determining  the  financial  status  of  the  manufac- 
turer. Probably  the  best  way  of  treating  such  a  transac- 
tion is  by  establishing  a  special  reserve  to  provide  against 
an  uncertain  contingency,  rather  than  to  treat  it  as  an 
absolute  liability.  More  simple  is  the  case  where  accep- 
tances or  indorsements  are  given  as  an  accommodation  to 
trade  associates.  This,  of  course,  constitutes  a  real  liabil- 
ity and  should  at  once  appear  on  the  books  of  the  indorser, 
being  offset  by  an  asset  representing  the  claim  against  the 
one  who  has  been  accommodated.  Again  funds  may  be 
raised  by  indorsing  and  rediscounting  trade  paper,  in 
which  case  the  obligation  is  not  incurred  as  a  mere  accom- 
modation but  as  a  regular  business  transaction.  Pecul- 
iarly enough,  in  ordinary  bookkeeping,  such  obligations  are 
customarily  omitted.  The  discounting  of  the  trade  paper 
formerly  held  cancels  that  item  from  the  books  and  noth- 


LIABILITIES  193 

ing  further  appears  to  indicate  a  possible  obligation.  This 
is  in  contrast  to  usage  in  transactions,  which  at  heart  are 
identical,  that  is,  where  funds  are  obtained  on  the  prom- 
isor's own  note,  secured  by  trade  paper  as  collateral. 
Where  this  is  done  the  custom  is  to  show  the  trade  paper 
still  among  the  assets  and  the  collateral  note  itself  as  a  lia- 
bility. But  whether  the  funds  are  secured  by  indorsing 
the  trade  paper  and  rediscounting  it,  or  by  hypothecating 
it  as  collateral  does  not  affect  the  real  position  of  the  bor- 
rower. Yet  it  is  exceptional  to  exhibit  the  liability  as 
indorser  on  rediscounts,  the  usage  of  National  Banks  being 
the  most  prominent  example. 

A  dividend  which  has  been  declared  becomes  at  once  a 
liability  of  the  company  and  must  accordingly  be  shown  in 
the  Balance  Sheet.  This  corresponds  with  the  legal  posi- 
tion, for  while  undivided  profits  are  not  a  liability  of  the 
corporation,  and  the  stockholders  have  no  right  to  compel 
their  distribution,  the  declared  dividend  is  an  obligation, 
for  which,  in  case  of  bankruptcy,  the  stockholder  has  the 
same  rights  that  any  other  creditor  has  against  the  com- 
pany. Undeclared  dividends  do  not  appear  at  all  on  the 
books,  unless  in  the  case  where  there  are  cumulative  pre- 
ferred dividends  in  arrears.  The  position  of  such  divi- 
dends is  somewhat  unique.  So  far  as  the  company  and  the 
preferred  stockholders  are  concerned  there  is  no  obligation 
to  pay,  indeed  the  company  cannot  pay  unless  profits  are 
earned.  But  from  the  view  point  of  the  common,  or  de- 
ferred stockholder  delinquent  cumulative  dividends  on 
preferred  stock  are  a  liability  which  must  be  met  before 
anything  can  be  paid  to  him.  Consequently  there  is  a 
good  argument  for  making  an  exhibit  of  the  amount  in 
arrears.  Practice  is,  however,  not  uniform  on  this  point. 
Perhaps  the  best  treatment  is  to  follow  Pixley's  suggestion 
that  they  appear  in  an  appendix  to  the  Balance  Sheet 
rather  than  in  that  statement  .itself. 


194  MODERN   ACCOUNTING 

The  provision  for  pensioning  employees  raises  a  ques- 
tion as  to  whether  there  exists  a  liability  which  should  ap- 
pear in  the  Balance  Sheet.  An  agreement  definitely  made 
to  pay  pensions  is  nothing  more  than  one  way  of  paying 
wages.  In  order  to  apportion  charges  properly  between 
years,  the  amount  necessary  to  provide  for  future  pensions 
must  be  counted  among  the  expenses  of  each  year ;  and  th& 
corresponding  sum  is  a  real  obligation  payable  to  employ- 
ees some  time  in  the  future.  Evidently  in  such  a  case  to 
omit  such  a  liability  from  the  Balance  Sheet  is  incorrect. 
But  if  the  provision  for  the  pensions  is  not  a  definite  mat- 
ter of  bargain,  but  is  rather  an  optional  beneficence  of  the 
proprietors,  the  accumulated  fund  is  of  the  nature  of  a  re- 
serve rather  than  a  liability.  In  some  cases,  where  the 
pension  system  is  well  established  the  annual  appropri- 
ations thereto  are  paid  to  trustees  who  hold  them,  and 
the  accumulations  thereon,  in  trust  for  the  beneficiaries. 
In  such  cases  both  the  assets  and  the  liability  entry  may 
properly  be  left  entirely  out  of  the  accounts  of  the  com- 
pany. Here  the  payment  of  wages  consists  of  two  parts, 
one  paid  currently  to  the  workman,  the  other  paid  to  his 
trustees.  After  such  payment  the  company  need,  in 
neither  case,  make  further  accounting.  The  treatment  of 
pensions  therefore  depends  on  the  exact  legal  nature  of  the 
pension  agreement,  and  on  the  financial  policy  adopted  in 
its  administration. 

BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  X 

DICKINSON,  A.  L.     Interest  and  Sinking  Funds.    Accountant,  XVII, 

p.  715. 
PIXLEY,  F.  W.     Auditors,  their  Duties  and  Responsibilities,  I,  pp. 

351-357.     Ninth  edition.     London,  1906. 
REHM,  H.     Loc.  tit.,  pp.  272-342,  477-493. 
SIMON,   H.  V.    Loc.  tit.,  pp.    173-201.    [The  last  two  authors 

present  opposing  views  of  the  nature  of  discount  on 


CHAPTER    XI 

PROFITS 

THE  Profit  and  Loss  Account,  called  also  Revenue, 
Income,  Loss  and  Gain  and  other  similar  names,  is  a  tem- 
porary, collective  account,  recording  the  changes  in  net 
wealth  due  to  the  business  operations  of  a  stated  period. 
In  some  cases  it  indicates,  as  well,  the  disposition  which 
has  been  made  of  the  net  profits.  It  is  temporary,  as  it 
covers  only  a  given  period,  usually  the  fiscal  year,  and  is 
in  the  end  closed  out,  in  partnerships  by  being  divided 
between  the  proprietors'  accounts,  in  corporations  by 
transference  to  Dividends,  Reserve,  Surplus,  or  other  simi- 
lar accounts.  It  is  a.  collective  account  in  that  it  embraces 
the  balances  shown  by  other  subsidiary  ' '  Proprietorship  ' ' 
accounts,  such  as  expense  or  the  various  subdivisions  there- 
of, and  the  various  accounts  indicating  profits  received 
during  the  year,  such  as  Merchandise,  Interest,  Rent.  It 
shows  changes  in  net  wealth  and  is  therefore  subsidiary 
to  the  Capital,  or  other  main  proprietorship  accounts.  It 
shows  not  merely  the  net  wealth  as  a  single  sum,  nor 
the  accretions  of  wealth  during  the  entire  previous  busi- 
ness career,  as  distinct  from  the  original  capital,  but  as 
well,  just  wThat  changes  in  the  net  wealth  have  been 
brought  about  during  the  fiscal  year.  It  shows,  properly, 
changes  due  to  business  operations,  not  those  due  to  other 
causes,  although  here  the  line  is  uncertain  and  practice 
unsettled. 

Like  other  accounts  it  contains  two  sides.  On  the  one 
are  entered  items,  of  which  Expense  is  the  type,  whose 
!4  195 


196  MODERN  ACCOUNTING 

effect,  per  se,  is  to  indicate  a  diminution  of  net  wealth. 
On  the  other  side  appear  items  which  indicate  an  increase 
in  net  wealth.  The  debit  side  may,  in  addition,  contain 
not  merely  expenses  and  losses,  but  also  the  disposition, 
or  allocation  of  the  net  profits,  which  sometimes,  as  when 
it  shows  dividends  paid,  indicates  a  reduction  of  the  net 
wealth  belonging  to  the  concern,  but  not  a  loss ;  and  some- 
times, as  when  a  sum  is  carried  to  Surplus  or  Reserve, 
merely  a  technical  bookkeeping  transfer. 

The  purpose  of  the  Profit  and  Loss  account  is,  primar- 
ily, to  show  the  net  profits  of  the  concern  for  the  period, 
with  special  reference  to  the  amount  of  net  profits  avail- 
able for  dividends.  This  may  at  times  be  derived  from 
the  Balance  Sheet,  indeed  some  writers,  of  whom  Rehm 
is  a  prominent  example,  claim  that  the  prime  purpose  of 
the  ordinary  Balance  Sheet  is  to  exhibit  profits  available 
for  dividends.  But  in  practice  this  is  not  true,  and  in 
any  case  the  Profit  and  Loss  account  by  its  greater  ex- 
plicitness  and  completeness  is  a  valuable  adjunct  to  the 
Balance  Sheet,  so  that  the  two  statements  are  generally 
published  together,  as  being  mutually  complementary. 

If  a  distinction  is  to  be  made,  it  may  be  said  that  the 
Balance  Sheet  interests  more  particularly  the  creditor, 
the  Profit  and  Loss  account  the  proprietor  or  stockholder. 
The  depositor  in  the  bank  finds  in  the  former  the  com- 
parison between  deposits  and  cash  reserves,  the  nature  of 
investments,  and  the  amount  of  guaranty,  facts  all  of 
which  affect  his  determination  as  to  continuing  his  ac- 
count. The  wholesale  merchant  learns  from  the  Balance 
Sheet  of  his  customer  the  relation  of  assets  to  liabilities, 
and  the  kind  of  each,  and  decides  as  to  increasing  the  line 
of  credit.  The  stockholder,  on  the  other  hand,  is  interested 
more  particularly  in  profits,  and  the  examination  of  the 
Profit  and  Loss  account  should  show  him  whether  the  stook 
is  a  desirable  investment.  But  the  distinction  here  made 


PEOFITS  197 

is  only  relative.  The  creditor  is  unwilling  to  continue  to 
trust  a  losing  concern,  and  the  investor  will  resist  the 
temptation  to  buy  stock  with  high  dividends,  if  these  are 
gained  by  doing  a  business  with  insufficient  reserves  and 
imminent  liability  to  bankruptcy.  So,  creditor  and  pro- 
prietor alike  need  both  Balance  Sheet  and  Profit  and  Loss 
statement  to  give  the  information  desired  in  business  nego- 
tiations. 

Before  considering  more  particularly  the  details  of  the 
Profit  and  Loss  account  and  the  problems  pertaining  to  it, 
it  is  necessary  to  show'  the  connection  between  this  account 
and  the  various  classes  of  accounts  which  were  discussed 
in  the  preceding  chapters. 

The  Profit  and  Loss  account  being  merely  a  subdivision 
of  the  Capital  account  and  indicating  current  changes  in 
the  net  wealth,  it  is  evident  that  its  connection  with  the 
Goods  accounts  is  most  vital.  Any  changes  in  the  net 
value  of  the  assets  must,  with  certain  exceptions  to  be 
noted  later,  be  reflected  in  the  Profit  and  Loss  account.. 
Consequently,  any  of  the  transactions  previously  discussed, 
or  any  of  the  bookkeeping  estimates  which  more  or  less 
accurately  portray  transactions  affecting  the  book  value  of 
the  assets,  must  also  be  represented  in  the  Profit  and  Loss 
account.  Any  change  in  the  Goods  accounts,  representing 
business  changes  other  than  mere  exchange  transactions, 
must,  in  ordinary  cases  have  a  counter  entry  which  is  ulti- 
mately included  in  the  items  posted  to  the  Profit  and  Loss 
account. 

The  problems  of  Profit  and  Loss  are  generally,  then, 
not  new  questions  but  the  same  that  have  already  been  dis- 
cussed. The  valuation  of  assets  (the  problem  of  the  inven- 
tory) is  clearly  a  question  as  to  Profit  and  Loss,  for  changes 
in  the  book  value  of  assets  mean  corresponding  changes  in 
the  net  wealth.  The  .question  as  to  whether  Organization 
Expenses  should  go  into  the  inventory  is  clearly  a  ques- 


198  MODERN  ACCOUNTING 

tion  as  to  whether  they  should  be  kept  out  of  the  Profit 
and  Loss  account.  Depreciation,  if  established,  must  be 
booked  by  a  charge  to  Profit  and  Loss.  Thus  the  Profit 
and  Loss  account  is  merely  another  view  of  the  general 
problems  of  accounting,  and  much  which  has  already  been 
discussed,  while  pertinent  to  the  consideration  of  Profit 
and  Loss  need  not  be  repeated  in  this  chapter. 

Most  of  the  charges  made  to  the  Profit  and  Loss  ac- 
count are  unequivocal  and  undisputed.  An  expense  is,  in 
most  cases,  easily  recognized,  and  the  necessity  for  charg- 
ing expenses  against  Profit  and  Loss  is  generally  not  ques- 
tioned. But  there  are  two  classes  of  cases  in  which  a  di- 
lemma really  arises  as  to  whether  a  given  item  should 
appear  in  the  Profit  and  Loss  account  or  elsewhere.  In 
the  first  class  the  alternative  to  entering  it  in  the  Profit 
and  Loss  account  is  to  include  it  among  the  Goods  listed 
in  the  inventory.  In  the  second  class  the  alternative  is 
the  entry  in  the  Capital  account  direct,  or  where  that  is 
impossible  because  of  the  requirements  of  corporation  law, 
the  entry  into  some  subsidiary  account  showing  that  a 
deduction  should  be  made  in  the  nominal  capital,  but  one 
which  need  not  go  through  the  medium  of  the  Profit  and 
Loss  account. 

1.  The  first  of  these  problems  has  been  discussed  in  con- 
nection with  the  inventory.  Is  the  interest  paid  during 
construction,  is  the  expense  of  organization,  a  real  loss, 
something  to  be  debited  against  profits,  or  is  the  payment 
represented  by  an  immaterial  asset,  or  at  least  by  a  De- 
ferred Charge,  which  for  present  purposes  is  to  be  con- 
sidered as  an  asset?  Was  the  money  paid  for  improving 
the  road-bed  properly  an  expense,  or  is  it  an  added  ele- 
ment in  the  cost  of  construction  and,  as  such,  to  appear 
among  the  assets?  Assets  and  losses,  expenses  and  im- 
provements, exchange  transactions  and  those  affecting  net 
wealth,  are  mutually  exclusive  conceptions.  Determina- 


PEOFITS  199 

tion  that  a  disbursement  was  for  one  of  these  purposes 
excludes  it  from  the  other,  so  that  all  this  class  of  ques- 
tions is  merely  a  restatement  of  the  problem  of  the  in- 
ventory already  discussed. 

2.  The  second  alternative  is,  however,  a  new  one.  The 
alternative  to  an  entry  in  the  Profit  and  Loss  account, 
is  here  an  entry,  not  among  the  assets  but  in  some  other 
of  the  accounts  which  have  here  been  called  "  Proprietor- 
ship "  accounts.  Exclusion  from  Profit  and  Loss  does  not 
here  force  an  inclusion  in  the  other  group  of  accounts, 
representing  assets.  It  means  that  an  actual  deduction  in 
net  wealth  has  taken  place  and  that,  if  this  is  not  to  ap- 
pear in  the  account  showing  current  business  changes  in 
net  wealth  (the  Profit  and  Loss  account),  it  must  appear 
in  some  other  of  the  same  group,  either  in  the  Capital 
account  itself,  or  in  some  account,  other  than  Profit  and 
Loss,  which  is  subsidiary  to  the  Capital  account.  In  a 
word,  the  question  is  whether  all  changes  in  net  wealth 
should  go  through  the  Profit  and  Loss  account.  Can  capi- 
tal be  lost,  without  having  such  a  technical  loss  as  must 
appear  in  the  debit  of  the  Profit  and  Loss  account?  May 
there  be  an  increase  in  the  net  value  of  the  assets,  repre- 
senting a  growth  of  capital,  but  not  profits  in  the  sense 
that  is  meant  by  a  Credit  balance  to  the  Profit  and  Loss 
account  ? 

These  two  different  classes  of  perplexing  entries  may 
be  illustrated  by  referring  again  to  the  fundamental  equa- 
tion of  bookkeeping  in  which  the  total  Goods,  consisting 
of  plant  and  other  assets,  equal  the  total  Proprietorship, 
divided  into  original  capital  and  profits,  i.  e. 

Plant,  etc.,  $100,000  -f-  Cash  $5,000  =  Capital  $95,000  -f 
Profits  $10,000. 

In  a  preceding  paragraph  reference  was  made  to  instances 
where  cash  is  paid  out,  say  for  an  improvement  in  the 


200  MODERN   ACCOUNTING 

road-bed.  The  dilemma  consisted  in  the  uncertainty 
whether,  Cash  being  thus  diminished,  the  validity  of  the 
equation  is  to  be  maintained  by  making  an  equivalent 
addition  to  the  other  term  of  the  Goods  account,  or  by  sub- 
traction from  Profits.  In  one  case  there  results 

Plant,   etc.   $101,000  +  Cash  $4,000  =  Capital  $95,000  +; 

Profits  $10,000, 
in  the  other  '."'(' 

Plant,   etc.  $100,000  +  Cash  $4,000  =  Capital  $95,000  +; 
Profits  $9,000. 

But  in  the  second  class  of  doubtful  entries  there  is  no 
question  as  to  the  lessening  of  total  values.  There  has 
been  a  decline,  say  in  the  value  of  the  plant,  amounting 
to  $1,000.  The  problem  here  is  virtually  whether  the  Bal- 
ance Sheet  should  show: 

Plant,    etc.    $99,000  +  Cash    $5,000  =  Capital    $95,000  '+• 
Profits  $9,000, 

or  whether  the  correct  statement  would  be  either : 

Plant,    etc.    $99,000  -f  Cash    $5,000  =  Capital   $94,000  -f 
Profits  $10,000, 

or  the  equivalent  expression: 

Plant,  etc.  $99,000  -f  Other  assets  $5,000  -f  Losses  $1,000 
=  Capital  $95,000  +  Profits  $10,000. 

In  practice,  a  still  different  and  incorrect  treatment  is 
given  to  the  transaction,  which  shows: 

Plant,  etc.  $100,000  -f  Other  assets  $5,000  =  Capital 
$95,000  +  Profits  $10,000, 

despite  the  undeniable  fact  that  certain  values  have  really 
disappeared. 

This   problem    has   been   discussed   at   length   by   the 
courts,  but,  unfortunately,  not  always  from  the  view  point 


PKOFITS  201 

/ 

of  accounting.  It  has  perhaps  been  worked  out  most  mi- 
nutely in  questions  of  probate,  where  a  life  interest  in  an 
estate  is  left  to  one  person  while  the  body  of  the  estate 
goes  to  some  other  legatee.  Here  it  is  of  vital  importance 
to  distinguish  between  the  income  going  to  the  tenant  for 
life  and  the  body  of  the  estate  going  to  the  remainder-man. 
In  this  relation  the  conception  has  been  introduced  of 
there  being  a  growth  or  increase  in  the  body  of  the  estate 
which  does  not  constitute ,  a  part  of  the  income.  Con- 
versely there  may  be  a  loss  of  part  of  the  principal  without 
effect  on  the  income  derived  from  the  remainder.  The 
theory,  while  well  worked  out  in  detail  in  its  application 
to  the  settlement  of  estates,  is  recognized  as  being  pecul- 
iar to  probate  law,  and  while  interesting  to  the  account- 
ant is  not  applicable  to  commercial  accounts.  Again  the 
matter  frequently  comes  up  in  bankruptcy  proceedings, 
where  the  liability  of  directors,  or  of  stockholders,  to 
creditors  turns  on  whether  a  certain  dividend  paid  was 
really  profit  earned.  In  disputes  arising  between  differ- 
ent classes  of  stockholders,  or  in  the  suits  brought  by  the 
holders  of  income  bonds,  there  has  also  frequently  arisen 
the  question  as  to  what  constitutes  profits.  But  in  most 
of  these  cases  the  decisions  are  not  so  conclusive  as  could 
be  desired.  Oftentimes  the  decision  turns  entirely  on  the 
construction  of  some  special  clause  in  the  articles  or  by- 
laws of  the  company,1  or  after  a  long  discussion  of  vital 
principles  the  case  is  finally  decided  on  some  technicality 
leaving  the  main  question  unsettled ; 2  or  in  general,  the 

1  For  instance  the  oft-quoted  decision  in  Davison  v.  Gillies  was 
subsequently  said  to  have  rested  entirely  on  special  articles  and  not  on 
general  law.  Vide  L.  R.  41  Ch.  Div.  18. 

*  For  instance  the  decision  on  the  appeal  of  the  National  Bank  of 
Wales  case.  Here  most  important  principles  were  raised  in  the  Court 
of  Appeal,  but  these  were  questioned  but  not  reversed  in  the  House  of 
Lords,  the  decision  being  made  on  a  technicality  as  to  the  defendant's 
responsibility.  Dovey  v.  Cory  [1901]  A.  C.  477. 


202 


MODERN  ACCOUNTING 


decision  is  at  best  a  decision  as  to  what  profits  are  avail- 
able for  dividends,  rather  than  as  to  what  constitutes 
profits. 

In  England  the  discussion  has  been  clearer  than  in  the 
United  States.  It  has  been  especially  favored  by  the  ex- 
ceptional form  for  the  Balance  Sheet  provided  for  parlia- 
mentary companies.  The  fact  that  the  Capital  account  is 
here  kept  separate,  as  in  the  simple  form 


Dr. 


FORM  73. 
Capital  Account. 


Cr. 


Capital  assets £95,000 

Balance 5,000 


£100,000 


Shares £100,000 


Dr. 


Balance  Sheet. 


£100,000 


Cr. 


Balance  of  Capital  Account  £5,000 

Accounts  payable 20,000 

Profits 5,000 

£30,000 


Bills  receivable £15,000 

Cash 15,000 


£30,000 


seems  to  encourage  the  idea  that  the  Capital  account,  or  at 
least  the  plant  purchased  with  receipts  from  capital  have 
little  or  nothing  to  do  with  the  profits  exhibited  in  the 
Balance  Sheet.  The  inference  is  easily  drawn  that  there 
can  be  a  loss  in  the  value  of  the  capital  Assets  which  would 
affect  only  the  Capital  account  and  which  would  leave  the 
profits  of  the  year  undisturbed.  Doubtless,  because  of 
being  accustomed  in  double  accounts  to  treat  capital  as  a 
thing  by  itself,  the  English  courts  have  been  more  ready 
to  take  advanced  ground  on  the  general  problem. 

Whatever  decision  may  ultimately  be  rendered  by  ac- 
countants, the  problem  at  least  is  clear.  Recognizing  the 
loss  of  certain  assets,  say  by  fire,  or  by  shipwreck,  by 


PEOFITS  .        203 

default  of  securities,  or  by  normal  exploitation,  the  only 
point  of  debate  is  as  to  the  channel  through  which  that 
loss  shall  be  shown.  In  accounting  terms  it  is  simply 
whether  a  given,  recognized  loss  is  to  be  debited  to  Profit 
and  Loss  or  to  some  other  account  which  would  indicate 
a  deduction  from  net  wealth,  but  which  would  say  nothing 
about  current  revenues.  To  a  certain  extent  it  is  a  ques- 
tion of  terminology,  in  part,  it  is  a  question  of  law.  Does 
the  term  "  Net  Profits  "  mean  the  net  change  in  wealth, 
due  to  whatever  cause,  or  does  it  mean  the  changes  due 
only  to  a  certain  set  of  business  factors?  Does  the  law 
allow  dividends  to  be  made  of  the  surplus  of  certain  re- 
ceipts (realized  or  constructive)  over  certain  expenses 
(whether  paid  or  merely  recognized),  or  does  it  order  that 
only  the  surplus  of  present  assets  over  the  net  assets  of  a 
year  ago  may  be  divided? 

The  problem  may  be  illustrated  by  assuming  a  case  of 
relative  simplicity  where  a  company  is  organized  to  pur- 
chase a  coal  mine  and  to  exploit  and  sell  the  coal.  Waiv- 
ing the  question  of  the  difficulty  of  making  an  intelligent 
estimate  of  the  value  of  the  coal  deposit,  it  may  be  assumed 
that  $250,000  is  paid  for  the  property  and  that  this  is  an 
equitable  price  for  the  million  tons  of  coal  which  the  mine 
contains.  On  these  terms  the  selling  price  should  return 
the  principal,  pay  all  the  operating  expenses,  and  yield 
a  fair  profit  on  the  original  investment.  The  proceeds  of 
each  year's  sales  obviously  should  considerably  exceed  the 
annual  cost  of  operating  the  mine ;  but  it  is  perfectly  clear 
that  the  excess  of  receipts  over  annual  expenditures  will 
not  all  be  profits.  Out  of  the  price  received  for  each 
ton  of  coal  25  cents  is  a  return  of  a  similar  sum  paid  orig- 
•  inally  for  the  coal  in  situ ;  and  allowance  for  this  cost  price 
must  inexorably  be  made  before  profits  can  correctly  be 
determined.  With  the  assumptions  made,  the  mining 
company  can  no  more  legitimately  treat  the  net  annual 


204 


MODEKN   ACCOUNTING 


receipts  as  net  profits  than  can  the  merchant  neglect  the 
cost  price  of  his  commodity,  or  the  manufacturer  disre- 
gard the  factory  cost  of  his  product  in  -  his  estimate  of 
profits.  Thus  assuming  again  that  the  total  cost  of  min- 
ing and  selling  the  coal,  including  all  the  direct  outlay  for 
operation,  amounts  to  55  cents  per  ton,  the  company,  after 
exploiting  100,000  tons,  should  show  in  its  Profit  and  Loss 
account : 

FORM  74. 
Dr.  Pro-fit  and  Loss.  Cr. 


Expenses $55,000 

Exhaustion  of  mine 25,000 

Balance  available  for  div- 
idends   20,000 

$100,000 


Sales $100,000 


$100,000 


and  having  paid  out  the  full  profits  the  Balance  Sheet 
should  show: 

FORM  75. 
Dr.  Balance  Sheet.  Cr. 


Cost  of  mine $250,000 

Cash,  etc 25,000 

$275,000 


Capital $250,000 

Depreciation  of  mine 25,000 

$275,000 


The  same  process  being  continued  until  all  the  coal  is  dis- 
posed of  the  Balance  Sheet  should  be : 


Dr. 


FORM  76. 
Balance  Sheet. 


Cr. 


Mine — cost 

price $250,000 

Less  exhaustion    250,000 


0 


Cash,  etc $250,000 

$250,000 


Capital $250,000 


$250,000 


PROFITS  205 

During  the  course  of  business  the  net  cash  receipts  amount 
to  $450,000,  but  because  of  charging  to  Profit  and  Loss 
a  sum  representing  the  cost  price  of  coal,  the  total  profits 
shown  and  distributed  amount  only  to  $200,000,  while 
there  steadily  accumulates  in  the  treasury  a  sum  which  at 
the  end  of  operations  equals  the  original  cost  of  the  mine.1 
This  would  serve  to  return  the  capital  stock. 

Such  treatment  of  the  accounts  met  with  the  practi- 
cally unanimous  approval  of  accountants,  when  in  1889, 
the  accounting  world  was  startled  by  the  now  historic  de- 
cision in  the  English  case,  Lee  v.  Neuchatel  Asphalte  Com- 
pany, Limited.  (L.  R.  41  Ch.  Div.  1.)  Here  action  was 
brought  by  a  shareholder  to  prevent  a  company  formed 
to  work  certain  asphalt  deposits  from  paying  dividends 
without  making  allowance  for  the  exhaustion  of  the  de- 
posits. But  the  court  refused  to  interfere.  Unfortunately 
for  the  peace  of  mind  of  accountants,  .jurists,  and  com- 
pany directors,  the  decision  itself  was  somewhat  vague  in 
principle,  contradictory  in  detail,  and  difficult  of  appre- 
hension. But  the  case  at  least  decided  the  principle  that 
there  is  no  requirement  compelling  companies  to  make  al- 
lowance for  the  exhaustion  of  their  capital  invested  in 
"  wasting  "  assets. 

So  counter  was  this  to  the  teaching  of  text-books,  and 
the  practice  of  accountants  that  it  immediately  attracted 
attention  and  criticism.  In  the  current  discussion  in  the 
Accountant,  the  organ  of  the  Chartered  Accountants,  it 
was  almost  universally  condemned.  It  was  claimed  that 
the  decision  showed  "  a  feeble  grasp  of  the  fundamental 
principles  of  accounting  "  and  to  be  "  utterly  at  variance 
with  the  views  of  all  practical  accountants  and  prudent 
men  of  affairs."  The  "  Dictionary  of  Political  Economy  " 
appearing  soon  after  the  decision  maintained  that  it  ' '  con- 

1  For  the  sake  of  simplicity  the  question  of  interest  accruing  on  this 
fund  is  disregarded. 


206  MODERN   ACCOUNTING 

tradicts  every  sound  principle  of  business  and  bookkeep- 
ing." Palmer,  one  of  the  most  eminent  authorities  on 
company  law  has  said:  "  The  views  on  Lee  are  not  shared 
by  some  other  learned  judges  and  they  do  not  commend 
themselves  to  the  common  sense  of  accountants,  economists, 
or  business  men  in  general, ' '  and  he  declares  its  system  oi 
ascertaining  profits  to  be  "  obviously  unsound." 

In  face  of  such  united  criticism  coming  from  such 
varied  authorities  it  requires  some  temerity  to  argue  in 
favor  of  the  decision;  especially  so  since  the  decision, 
while  it  has  frequently  been  followed  in  England  and  in 
the  United  States  x  has  been  said  to  have  really  no  bearing 
on  the  question  of  the  treatment  of  wasting  assets,  as  in 
reality  the  value  of  the  remaining  deposits  wras  greater 
than  the  original  price  paid  for  the  concession.2  It  should 
be  borne  in  mind  that  the  decision  was  not  expressed  in 
accounting  terms,  nor  was  it  a  decision  as  to  what  con- 
stituted profits,  but  merely  that  a  company,  organized  to 
work  a  wasting  property  might,  in  accordance  with  the 
terms  of  its  own  articles,  distribute  the  net  annual  receipts 
without  withholding  a  sum  to  represent  the  exhaustion  of 
the  mineral  deposits,  there  being  no  creditors  who  were 
thereby  harmed. 

In  the  above  case  the  question  related  solely  to  the 
treatment  of  the  income  of  a  company  specifically  organ- 
ized for  the  exploitation  of  wasting  assets,  or  as  it  is  loosely 
phrased,  "  with  wasting  capital."  The  nature  of  such  an 
enterprise  precludes  its  permanence.  The  more  successful 
its  operation,  the  shorter  its  life.  Like  Nan  Netticote,  of 
the  childish  conundrum,  the  more  brilliant  its  career,  the 

1  See  e.  g.  the  clear  and  important  decision  Excelsior  Water  &  Mining 
Company  v.  Pierce.  90  Cal.   131  (1891).     United  Verde  Copper  Co.  v. 
Roberts  156  N.  Y.  585  (1898). 

2  Bond  v.  Barrow  Haematite  Steel  Co.  [1902]  1  Ch.  353,  and  Wilmer 
v.  McNamara  &  Co.  [1895]  2  Ch.  245. 


PROFITS  207 

sooner  it  ends;  the  more  efficient  its  management  the  more 
quickly  will  its  resources  be  exhausted.  Such  an  enter- 
prise differs  radically  from  an  ordinary  industrial  under- 
taking where  the  element  of  permanence  and  continuity 
is  implied.  The  decision  in  Lee,  therefore,  did  not  neces- 
sarily apply  to  any  enterprise  other  than  those  with 
wasting  assets. 

Five  years  later  a  decision  almost  equally  important 
was  given  which  greatly  extended  the  idea  that  losses 
might  be  suffered  without  affecting  the  Profit  and  Loss 
account.  This  was  in  the  case  of  Verner  v.  The  General 
and  Commercial  Investment  Trust,  Limited  ( [1894]  2  Ch. 
239).  This  concerned  a  company  organized  to  purchase 
stock  of  various  other  companies,  the  sole  function  of  the 
Trust  being  to  make  speculative  investments  dividing  the 
net  income  as  dividends  to  its  own  stockholders.  The  in- 
vestments made  were  in  diverse  enterprises  and  were  made 
purely  for  the  sake  of  the  income  to  be  derived  therefrom. 
In  this  particular  instance,  nearly  $5,000,000  had  been 
raised  by  shares  and  debentures,  all  of  which  had  been  in- 
vested. But  some  of  the  investments  had  been  poorly  se- 
lected, and  many  of  the  investments  having  fallen  in  value, 
some  of  them  proving  altogether  worthless,  there  was  an 
admitted  loss  of  over  $1,000,000,  equal  to  one  quarter  of 
the  capital.  Receipts  of  interest  and  dividends,  however, 
largely  exceeded  the  current  expenses,  and  the  case  turned 
on  the  legitimacy  of  paying  these  net  receipts  as  dividends, 
instead  of  using  them  to  make  up  the  loss  due  to  the  de- 
cline in  the  value  of  the  investments.  The  decision  held 
that  such  dividends  were  proper,  despite  the  general  legal 
principle  that  dividends  may  not  be  paid  out  of  capital. 

Here  there  was,  of  course,  no  question  of  wasting  assets. 
Investments  were  not  made  for  the  purpose  of  exploitation 
and  exhaustion,  but  for  permanent  income.  In  the  deci- 
sion, Lord  Justice  Lindley  held  that  while  in  general  divi- 


208  MODERN   ACCOUNTING 

dends  cannot  legally  be  paid  out  of  capital,  yet  that  does 
not  imply  that  in  all  cases  the  loss  of  capital  must  be  made 
up  before  dividends  may  be  paid.  A  distinction  was  made 
between  the  loss  of  what  was  termed  fixed  capital  and  of 
circulating  capital.  Dividing  the  income  of  a  company, 
without  the  replacement  of  the  circulating  capital  con- 
sumed in  producing  the  income,  is  a  payment  of  a  divi- 
dend out  of  capital,  such  as  is  prohibited  by  law. 

"  Fixed  capital  may  be  sunk  and  lost  and  yet  the  excess 
of  current  receipts  over  current  payments  may  be  divided, 
but  floating  or  circulating  capital  must  be  kept  up,  as 
otherwise  it  will  enter  into  and  form  part  of  such  excess 
without  deducting  the  capital  which  formed  part  of  it 
will  be  contrary  to  law." 

In  this  decision  the  principle  that  capital  need  not  be 
kept  up  before  declaring  dividends,  which  in  Lee  v.  Neu- 
chatel  Asphalte  Company  was  applied  only  to  wasting 
capital,  was  extended  to  so-called  "  fixed  capital  "  per- 
manently invested  in  a  peculiar  enterprise  known  as  a 
trust.  In  the  following  year  the  doctrine  was  extended  in 
the  case  of  Wilmer  v.  McNamara  and  Company  ( [1895] 
2  Ch.  245)  where  a  decline  in  the  value  of  the  Goodwill 
of  a  company  was  held  not  to  interfere  with  the  payment 
of  dividends  on  the  ground  that  this  loss  also  was  one  of 
fixed  and  not  of  circulating  capital.  Even  more  far  reach- 
ing was  the  decision  in  the  Kingston  Cotton  Mill  Company 
case  ([1896]  1  Ch.  348)  that  the  rulings,  which  in  Lee 
and  Verner  were  applied  to  companies  of  a  peculiar 
nature,  would  also  apply  to  an  ordinary  manufacturing 
concern. 

In  the  case  of  the  National  Bank  of  "Wales  ([1899] 
2  Ch.  629)  a  decision  was  given  which  was  even  more 
sweeping  in  its  effect.  There  the  loss  which  had  occurred 
was  one  which  might  be  considered  a  loss  of  circulating 


PEOFITS  209 

capital,  for  it  was  due  to  the  shrinkage  in  the  value  of 
loans  made  by  the  bank.  But  the  decision  sanctioned  the 
payment  of  dividends  in  a  year  when  profits  had  been 
earned  despite  the  fact  that  the  losses  of  previous  years 
were  still  uncovered.  Soon  afterwards  Justice  Wright 
relying  probably  on  this  decision,  stated  in  the  case  of 
Crichton's  Oil  Company:  "  I  do  not  think  that  there  is 
any  rule  of  law  that  profit  on  one  year's  trading  cannot 
be  divided  merely  because  in  the  Profit  and  Loss  account 
there  is  a  deficit  over  on  the  balance  of  former  years." 
([1901]  2  Ch.  196.) 

A  similar  opinion  was  expressed  by  Vaughan  "Williams 
in  the  decision  in  the  case  of  Hoare  and  Company,  Lim- 
ited. ' ;  However  much  capital  you  have  lost  at  any  given 
date,  if  your  Profit  and  Loss  account  shows  a  profit  bal- 
ance, then  to  the  extent  of  that  profit  balance  you  are  en- 
titled to  distribute  that  money  as  dividend  notwithstand- 
ing the  fact  that  you  have  lost  capital  which  you  have  not 
replaced.'"'  ( [1904]  2  Ch.  208.) 

The  adoption  as  a  general  rule  of  the  principle  enun- 
ciated in  these  decisions  would  be  to  treat  each  year  as  a 
separate  unit,  and  if  a  judicious  arrangement  of  the  ac- 
counts could  be  made  so  as  to  show  alternately  net  annual 
profits  and  losses,  to  allow  a  continued  distribution  of 
dividends  despite  the  fact  that  there  was  a  constantly 
growing  deficit  due  to  the  loss  of  circulating  as  well  as 
fixed  capital.1 

The  validity  of  the  decision  in  the  National  Bank  of 
Wales  case  has,  however,  been  very  seriously  questioned, 
for  although  it  was  upheld  in  the  House  of  Lords  (Dovey 
v.  Cory  [1901]  A.  C.  477)  the  judgment  in  the  last  court 
was  bused  entirely  on  technical  grounds,  relating  to  the 
liability  of  the  defendant  director,  and  in  no  way  vouched 
for  the  correctness  of  the  doctrines  relating  to  profits. 

1  See  F.  B.  Palmer,  Company  Precedents,  I,  p.  764. 


210  MODERN   ACCOUNTING 

Furthermore,  each  one  of  the  Lords  rendering  opinions  in 
the  latter  case  took  unusual  pains  to  call  attention  to  the 
the  fact  that  his  approval  of  the  decision  of  the  lower  court 
did  not  imply  approval  of  the  doctrine  there  enunciated 
as  to  the  treatment  of  lost  banking  capital.  Again  in  1904 
it  was  held  that  where  a  company  showed  a  deficit  from  a 
preceding  year,  it  was  illegal  to  pay  as  dividends  the  prof- 
its earned  later  until  the  preexisting  deficit  had  been  made 
up,  and  that  such  a  dividend  was  a  payment  out  of  cap- 
ital. (Towers  v.  African  Tug  Co.  [1904]  1  Ch.  558).  But 
unfortunately  no  discussion  is  given  of  the  principle  in- 
volved, for  the  decision  concerned  the  competency  of  cer- 
tain stockholders  to  sue  and  not  the  legitimacy  of  the 
dividend  which  was  assumed  to  be  illegal  without  discus- 
sion. And  the  significance  of  the  decision  in  Verner  is 
somewhat  lessened  by  the  later  important  case  of  Bond  v. 
Barrow  Hasmatite  Steel  Company  ([1902]  1  Ch.  353) 
where,  while  accepting  the  earlier  decisions  regarding  the 
loss  of  fixed  or  wasting  capital  as  binding,  the  court  re- 
garded damages  to  iron  mines  and  the  destruction  of  a 
blast  furnace  and  workmen's  cottages  as  all  being  losses 
of  circulating,  not  of  fixed  capital. 

The  latter  decision  emphasizes  the  unsatisfactoriness  of 
the  distinction  which  the  courts  have  attempted  to  draw 
between  a  loss  of  fixed  and  one  of  circulating  capital.  If 
by  this  is  meant  a  loss  of  fixed  and  circulating  assets,  there 
is,  of  course,  the  difficulty  already  alluded  to  of  determin- 
ing in  any  concrete  case  which  class  of  assets  has  been  lost. 
As  the  Lord  Chancellor  said  in  Dovey  v.  Cory,  "  The  dis- 
tinction between  fixed  and  floating  capital,  which  may  be 
appropriate  enough  in  an  abstract  treatise  like  Adam 
Smith's  '  Wealth  of  Nations  '  may  with  reference  to  a 
concrete  case  be  quite  inappropriate." 

In  no  system  of  classification  known  to  economists  from 
Adam  Smith  down  is  an  iron  furnace  included,  as  it  has 


PKOFITS  211 

been  included  by  the  court,  in  the  list  of  circulating  cap- 
ital. But  the  objection  to  this  distinction  from  the  tech- 
nical view  point  of  accounting  is  even  more  serious.  Part 
of  the  assets  may  be  lost,  but  no  particular  asset  is  an 
embodiment  of  any  particular  credit  in  the  Balance  Sheet. 
The  asset  in  question  may,  indeed,  have  been  bought  with 
the  cash  paid  in  on  subscriptions  to  Capital  Stock,  or  from 
the  proceeds  of  an  issue  of  bonds,  or  by  incurring  float- 
ing debt,  or  by  investing  the  profits  of  the  business.  But 
the  destruction  of  this  particular  asset  is  not  thereby  made 
specifically  a  loss  of  Capital,  or  of  Funded  Debt,  or  of 
Current  Liabilities,  or  of  Profits.  To  the  accountant  the 
distinction  between  the  Credit  items  in  the  Balance  Sheet 
and  the  Assets  is  vital.  They  represent  entirely  different 
conceptions  and  are  not  to  be  confused. 

The  decisions  of  the  American  courts  are  perhaps  even 
more  confusing  and  less  satisfactory.  This  is  striking  be- 
cause of  the  fact  that  in  this  country  the  courts  have  clung 
rather  tenaciously  to  an  invention— now  happily  obsoles- 
cent— of  Justice  Story,  that  the  capital  stock  of  a  corpora- 
tion is  a  trust  fund,  to  be  held  for  the  benefit  of  the  credi- 
tors. So  rigid  a  doctrine  would  seem  to  carry  with  it  an 
unusual  care  that  the  capital  should  not  be  encroached 
upon.  While  the  courts  have,  of  course,  rigorously  op- 
posed the  direct  payment  of  dividends  out  of  capital,  it 
has  already  been  shown  that  there  has  been  no  consistent 
recognition  of  depreciation.  As  to  the  specific  question  of 
the  loss  of  capital  as  something  distinct  from  the  loss  of 
profits,  the  most  striking  decision  is  that  of  the  Supreme 
Court  of  the  United  States  in  the  case  of  Eyster  v.  Cen- 
tennial Board  of  Finance :  ' '  The  receipts  of  the  exhibition, 
over  and  above  its  current  expenses  are  the  profits  of  the 
business.  ...  They  are,  in  fact,  the  net  receipts,  which, 
according  to  the  common  understanding,  ordinarily  repre- 
sent the  profits  of  the  business.  The  public,  when 
15 


212  MODERN   ACCOUNTING 

ring  to  the  profits  of  the  business  of  a  merchant,  rarely 
ever  take  into  account  the  depreciation  of  the  buildings 
in  which  the  business  is  carried  on,  notwithstanding  that 
they  may  have  been  erected  out  of  the  capital  invested. 
Properly  speaking,  the  net  receipts  of  a  business  are  its 
profits.  So  here,  as  the  business  to  be  carried  on  was  that 
of  an  exhibition  and  its  profits  were  to  be  derived  only 
from  its  receipts,  to  the  popular  mind  the  net  receipts 
would  represent  the  net  profit."1  (94  U.  S.  503.) 

In  this  case  the  enterprise  was  a  peculiar  one,  analo- 
gous to  a  single  ship  venture;  and  perhaps  to  be  decided 
on  rules  different  from  those  of  ordinary  mercantile  under- 
taking. In  the  case  of  Main  v.  Mills,  a  Federal  Court  de- 
clared: "  There  is,  perhaps,  at  this  day  no  better  estab- 
lished rule  of  law  than  that  the  capital  stock  of  a  moneyed 
corporation,  whether  it  be  a  banking,  insurance,  mining, 
or  manufacturing  company  is  to  be  treated  and  deemed  as 
a  trust  fund  for  the  purpose  of  securing  the  payment  of 
the  debt  of  the  corporation.  .  .  .  The  officers  of  such  a 
corporation  have  no  right  to  make  dividends  to  stockhold- 
ers unless  there  are  profits  to  be  divided,  over  and  above 
all  losses,  because  the  necessary  result  of  so  doing  is  to 
deplete  the  capital  fund.  ...  If  there  are  gains  and  losses, 
the  gains  should  be  set  off  against  the  losses  so  far  as  may 
be  necessary  to  keep  the  capital  fund  whole."  (16  Fed. 
Gas.  506  (1874).) 

The  State  courts  have  varied  in  their  decisions.  The 
most  interesting  decisions  are  in  Connecticut — that  "  net 
profit  ordinarily  means  what  is  left  after  making  good  the 
capital  ";  in  Michigan,  where  net  profits  are  said  to  be 
ascertained  by  a  comparison  of  present  assets  at  actual 


1  It  is  to  be  noted  here  that  the  depreciation  referred  to  is  not  the 
ordinary  wear  and  tear  due  to  time's  ravages,  but  the  loss  of  value, 
save  as  junk,  of  the  buildings  when  the  exhibition  closed. 


PEOFITS  213 

values,  with  the  total  original  investment;  in  Iowa,  where 
profits  are  made  equal  to  assets,  at  actual  value,  less  lia- 
bilities; and  in  California,  and  New  York  where  the  de- 
cision in  Lee  v.  Neuchatel  Asphalte  Company,  is  openly 
applied  to  the  dividend  of  a  local  mining  company.1 


1  The  cases  referred  to  are:  Getting  v.  N.  Y.  &  N.  E.  R.R.  Co.  54 
Conn.  156  (1886);  Richardson  v.  Buhl  77  Mich.  632  (1889);  Hubbard 
v.  Weare  79  la.  678  (1890);  Excelsior  Water  &  Mining  Co.  v.  Pierce, 
90  Cal.  131  (1891);  and  United  Verde  Copper  Co.  v.  Roberts,  156 
N.  Y.  585. 


CHAPTER   XII 

PROFITS  (continued) 

THE  questions  concerning  the  relation  between  capital 
losses  and  the  payment  of  dividends  are  threefold.  The 
first  is  as  to  the  legality  of  such  dividend;  the  second  is 
as  to  the  business  policy;  and  the  third  as  to  the  proper 
booking  of  such  transactions.  Each  of  these  may  in  turn 
be  subdivided  as  referring  to  Wasting  Capital  in  the  tech- 
nical sense,  to  ordinary  Fixed  Capital,  using  the  term 
loosely,  and  to  Circulating  Capital.  1.  The  legality  of 
dividends,  where  the  "  loss  "  is  merely  an  exhaustion  of 
wasting  capital  is  well  established  both  in  England  and 
in  this  country.  That  dividends  are  legal  despite  the  loss 
of  fixed  capital  is  supported  by  high — but  not  the  high- 
est—authority in  England  and  by  the  United  States  Su- 
preme Court,  with  the  State  courts  divergent.  But  "  all 
of  the  authorities  agree  that  circulating  capital  must  be 
kept  up."  (Bond  v.  Barrow  Haematite  Steel  Co.  [1902] 
1  Ch.  353.) 

2.  The  question  as  to  the  business  policy  of  making 
dividends  despite  losses  of  capital  is,  however,  independent 
of  the  legality  of  such  action.  It  is  most  easily  decided 
where  the  loss  is  of  the  first  class,  that  is  a  loss  of  wasting 
capital,  or  taking  the  typical  case,  where  the  operations  of 
the  company  consist  in  exploiting  a  mine.  It  has  already 
been  shown  how  the  decision  in  Lee  v.  Neuchatel  Asphalte 
Company  was  almost  universally  criticised.  Even  Pixley 
in  his  latest  edition  of  Duties  of  Auditors,  styles  the  pay- 
ment of  such  dividends  "  a  suicidal  policy  and  contrary 

214 


PEOFITS  215 

• 

to  the  practice  of  soundly  managed  public  companies  " 
and  "  distinctly  unwise  and  unbusinesslike." 

Despite  the  high  authority  of  the  critics  cited  there  is 
strong  reason  for  justifying  the  payment  of  dividends 
without  making  allowance  for  the  exhaustion  of  the  mine. 
The  discussion  reduces  itself  to  the  question  whether  min- 
ing and  similar  enterprises  are  to  be  regarded  as  perma- 
nent undertakings,  the  capital  of  which  should  be  main- 
tained, or  as  temporary  ventures  corresponding  to  the 
character  of  the  natural  resources,  from  which  capital  as 
well  as  profits  may  be  withdrawn  as  quickly  as  may  be 
possible  without  injuring  creditors  or  impairing  credit. 
Those  holding  the  former  view  claim  that  so  much  of  the 
receipts  as  represents  the  return  of  capital  should  be  re- 
served by  the  company,  and  invested  so  that  at  the  time 
of  the  final  exhaustion  of  the  mine  it  would  own  other 
assets  equaling  the  entire  amount  of  the  capital  stock. 

This  view  seems  entirely  to  overlook  the  essential  char- 
acter of  the  enterprise.  A  mining  venture  is  always  a 
speculative  undertaking.  Subscribers  to  the  capital  know 
well  that  in  the  nature  of  things  it  cannot  be  a  permanent 
undertaking,  and  presumably  they  are  aware  of  its  specu- 
lative character.  Their  sole  object  is  to  exploit  a  given 
deposit  of  mineral,  and  the  logical  thing  seems  to  be  to 
have  the  fruits  of  such  exploitation  turned  back  to  the 
subscribers  as  quickly  as  may  be.  Granting  that  creditors 
are  not  misled  nor  harmed  (and  protection  can  easily  be 
secured  by  contract)  it  seems  absurd  to  require  that  a 
body  of  capitalists  willing  to  invest  in  a  peculiar  specu- 
lative enterprise  should  be  forced  to  form  what  is  prac- 
tically a  trust  company  to  invest  part  of  the  annual  receipts 
against  some  far  distant  day  of  accounting.  If  one  pre- 
fers a  speculative  enterprise  with  possible  large  gains,  what 
is  more  unreasonable  than  to  require  that  his  venture 
should  gradually  be  transformed  into  something  entirely 


216  MODERN  ACCOUNTING 

different,  an  investment  in  long  time  and  low  rate  secu- 
rities. Better  by  all  means,  unless  it  is  thought  that 
paternalistic  laws  should  force  him  willy-nilly  to  become 
conservative,  to  turn  back  to  him  the  proceeds  of  the  ex- 
ploitation and  allow  him  to  make  another  similar  venture 
if  he  sees  fit. 

Moreover,  the  very  nature  of  the  organization  prob- 
ably is  an  argument  against  the  accumulation  of  a  reserve. 
The  officers  of  the  mining  company  presumably  were  se- 
lected because  they  knew  how  to  mine.  But  this  so  far 
from  supporting,  furnishes  a  presumption  against,  the  sup- 
positjon  that  they  are  desirable  persons  to  keep  and  admin- 
ister a  large  trust  fund.  From  all  points  of  view  it  seems 
much  more  sensible  to  allow  the  gradual  return  of  capital 
invested  in  an  enterprise  which  by  its  nature  is  termin- 
able, than  to  demand  the  accumulation  of  a  sinking  fund. 

A  dictum  of  the  United  States  Supreme  Court,  al- 
though given  in  other  circumstances,  is  pertinent  to  this 
discussion:  "  A  stockholder  (said  Mr.  Justice  Davis  in 
Clearwater  v.  Meredith)  enters  into  a  contract  with  the 
company  that  his  interest  shall  be  subject  to  the  direction 
and  control  of  the  proper  authorities  of  the  corporation 
to  accomplish  the  object  for  which  the  company  was  or- 
ganized. He  does  not  agree  that  the  improvement  to 
which  he  subscribed  should  be  changed  in  its  purposes  and 
character  at  the  will  and  pleasure  of  a  majority  of  the 
stockholders  so  that  new  responsibilities  and,  it  may  be, 
new  hazards  are  added  to  the  original  undertaking.  He 
may  be  willing  to  embark  in  one  enterprise  and  unwilling 
to  engage  in  another.  (68  U.  S.  40.) 

This  statement  was  made  regarding  an  extension  of 
a  line  of  railroad  out  of  profits  which  otherwise  would 
have  been  distributed  to  the  stockholders.  If  it  applies 
to  a  mere  extension  of  a  similar  enterprise,  much  more 
should  it  hold  as  regards  enterprises  so  utterly  divergent 


PEOFITS  217 

in  character  as  the  speculative  exploitation  of  a  mine,  and 
the  establishment  of  a  trust  fund.  x 

On  the  other  hand  there  are  certain  circumstances  in 
which  it  might  be  highly  desirable  for  the  company  to 
withhold  a  sum  corresponding  to  the  exhaustion  of  the 
wasting  capital  and  reinvest  in  other  similar  enterprises. 
Thus  a  manufacturing  company  owning  its  own  coal  or 
iron  mines  might  most  wisely  reinvest  in  new  mines  as  the 
old  ones  were  depleted.  But  this  is  a  special  case.  All 
that  is  claimed  is  that  there  should  be  no  general  rule  that 
there  must  be  a  withholding  of  receipts.  Even  a  reinvest- 
ment in  a  similar  enterprise  requires  special  justification ; 
the  creation  of  a  fund  to  be  invested  in  outside  securities  of 
an  entirely  different  nature  is  much  less  to  be  favored. 

The  policy  of  paying  dividends  despite  the  loss  of  cap- 
ital where  the  investment  was  in  other  than  wasting  prop- 
erty is  not  so  easily  defended.  Here  there  is  a  real  loss, 
not  a  return  of  capital;  here  the  enterprise  is  normally  a 
permanent  not  a  terminating  one;  here  the  whole  purpose 
of  the  enterprise  is  not  to  exhaust  and  return  the  capital 
but  to  use  it  in  business. 

Circumstances  may,  however,  justify  even  such  a  pay- 
ment of  dividend.  For  instance,  an  individual's  entire 
income  is  derived  from  ten  houses  each  worth  $10,000  and 
each  yielding  10  per  cent,  net  income.  If  two  of  these 
houses  burn  down,  uninsured,  the  common  sense  view 
is  that  the  proprietor's  income  is  thereby  cut  down  from 
$10,000  to  $8,000  per  annum,  and  that  coincidentally 
there  is  a  loss  of  capital  of  $20,000.  It  never  occurs  to 
him  that  he  must  consider  his  income  as  entirely  cut  off 
for  two  years  until  the  principal  can  be  restored.  Sim- 
ilarly it  might  be  an  act  of  cruelty  to  dependent  stock- 
holders to  stop  dividends  entirely  until  an  exceptional  loss 
is  reimbursed.  The  main  difficulty  is  that  in  a  corpora- 
tion such  an  occurrence  really  calls  for  a  reduction  of 


218  MODERN   ACCOUNTING 

the  nominal  capital,  a  cancellation  of  part  of  the  capital 
stock.  The 'red  tape  and  legal  expense  of  doing  this,  per- 
haps too  the  bad  effect  on  the  company's  credit  of  giving 
public  notice  that  there  has  been  an  encroachment  on  cap- 
ital, make  directors  loath  to  do  so.  The  criticism  properly 
to  be  made  is  not  so  much  that  dividends  are  paid  before 
restoring  the  capital  (i.  e.,  increasing  the  assets  until  they 
again  equal  the  capital),  but  rather  that  the  capital  stock 
has  not  been  reduced  to  correspond  with  the  amount  of  re- 
maining assets,  before  the  dividend  is  paid.  To  allow  divi- 
dends to  be  paid  while  assets  are  less  than  the  nominal 
capital  seems  to  render  nugatory  all  the  legal  provisions 
regarding  the  reduction  of  capital  stock.  Why  enact  such 
careful  legal  restrictions  and  yet  suffer  the  same  results 
to  be  reached  by  the  methods  permitted  in  the  case  of  the 
General  and  Commercial  Trust?  The  hardship  of  going 
entirely  without  dividends  for  a  series  of  years  may  per- 
haps be  considered  only  a  fair  return  for  the  exceptional 
privileges  granted  to  stockholders. 

As  to  the  policy  of  paying  dividends  when  there  nas 
been  a  loss  of  so-called  "  circulating  capital  "  there  is  no 
argument,  provided  the  meaning  of  that  phrase  is  taken  to 
be  that  the  income  of  the  company  is  less  than  the  outgo, 
and  furthermore  that  there  is  no  accumulated  reserve  out 
of  which  dividends  can  be  paid.  Certainly  if  nothing  has 
been  earned  all  agree  that  there  should  be  no  dividends. 

3.  The  critics  generally  assume  that  the  courts  justify 
the  Neuchatel  Asphalte  Company  and  the  General  and 
Commercial  Trust  in  presenting  accounts  misleading  and 
incorrect.  Thus  Palmer  in  his  masterly  work  on  Company 
Precedents  says :  ' '  The  views  expressed  in  Verner  v.  Gen- 
eral and  Commercial  Investment  Trust  involve  the  propo- 
sition .  .  .  that  the  Balance  Sheet  need  not  disclose  the 
true  condition  of  the  company.  It  deals  as  regards  the 
assets  not  with  existing  facts  but  with  past  history.  It 


PKOFITS  219 

shows  what  the  particular  assets  cost,  not  what  they  are 
worth.  Thus  if  a  company  buys  a  property  for  £10,000  and 
the  value  has  fallen  to  £1,000,  it  will  properly  be  entered 
on  the  Balance  Sheet  as  property  that  cost  £10,000 ;  and  it 
will  remain  at  that  figure,  even  though  each  year,  by  con- 
sumption or  otherwise,  it  depreciates  more  and  more. ' '  * 
This  implies  that  the  court  justifies  the  use  of  the  last  form 
given  on  page  200.  But  this  opinion,  which  is  shared 
by  many  another  critic,  not  merely  ignores  the  possibilities 
of  accounting  technic,  but  more  strangely  disregards  the 
express  words  of  the  decision  itself  in  which  Lord  Justice 
Lindley  states:  "It  is  obvious  that  capital  lost  must  not 
appear  in  the  accounts  as  still  existing  intact ;  the  accounts 
must  show  the  truth  and  not  be  misleading  or  fraudulent. ' ' 
( [1894]  2  Ch.  267.)  Similarly  in  the  later  case  of  Barrow 
Haematite  Steel  Company  (  [1900]  2  Ch.  857)  Justice 
Cozens-Hardy  very  clearly  intimates  that,  although  a  loss 
of  capital  may  not  prevent  the  Pj-ofit  and  L.OSS  account 
from  showing  a  balance  available  for  dividends,  the  Bal- 
ance Sheet  would  at  the  same  time  show  or  imply  the  loss 
which  had  taken  place. 

While  the  professional  accountant  sometimes  advises  a 
client  as  to  the  legality  of  certain  transactions,  the  lan- 
guage of  accounting  is  itself  not  concerned  with  legal  tech- 
nicalities. Whether  or  not  the  law  permits  a  company  to 
hold  its  own  stock,  to  issue  stock  or  bonds  below  par,  to 
make  stock  dividends,  or  as  in  the  case  here  to  pay  divi- 
dends while  assets  are  less  than  the  nominal  capital  is  an 
important,  but  purely  legal  matter.  If  the  transaction 
named  has  taken  place  the  question  as  to  its  technical 
legality  has  not— or  at  least  should  not  have— anything 
to  say  as  to  the  statement  of  facts  by  the  accountant.  It 
may  be  logical  to  claim  that  all  losses  or  gains,  however 
caused,  should  go  to  Profit  and  Loss,  and  not  direct  to  some 

» Vol.  I,  p.  757. 


220 


MODERN   ACCOUNTING 


other  Proprietorship  account.  But  such  a  claim,  while 
logical  enough,  does  not  at  all  conform  to  accounting  prac- 
tice of  any  land  or  time.  Once  granted  that  some  losses 
need  not  appear  to  the  debit  of  Profit  and  Loss,  the  duty 
of  the  accountant  is  plain,  and  his  task  is  simplicity  itself. 
The  loss— say  that  cited  by  Palmer— being  excluded  from 
Profit  and  Loss  must  appear  elsewhere.  If  law  requires 
or  permits  the  reduction  of  nominal  capital  stock,  and  that 
is  done,  the  loss  is  deducted  immediately  from  the  Capital 
account.  Thus  a  company  which  at  first  shows 


Dr. 


FORM  77. 
Balance  Sheet. 


Cr. 


Plant $10,000 

Miscellaneous  Assets 15,000 

$25,000 


Capital  Stock $22,000 

Profit  and  Loss 3,000 

$25,000 


will  after  the  unfortunate  experience,  have  as  its  Balance 
Sheet : 

FORM  78. 
Dr.  Balance  Sheet.  Cr. 


Plant $1,000 

Miscellaneous  Assets 15,000 

$16,000 


Capital  Stock  (reduced). .  $13,000 
Profit  and  Loss 3,000 

$16,000 


If  the  legal  steps  necessary  to  reduce  the  nominal  cap- 
ital have  not  been  taken,  the  showing  should  be: 


Dr. 


FORM  79. 
Balance  Sheet. 


Cr. 


Property $1,000 

Miscellaneous  Assets 15,000 

Loss  on  Capital  Account . .      9,000 

$25,000 


Capital  Stock $22,000 

Profit  and  Loss 3,000 

$25,000 


PKOFITS 


221 


Of  course  some  other  descriptive  term  may  be  used  in  place 
of  ' '  Loss  on  Capital  Account, ' '  the  only  requirement  being 
that  it  be  not  misleading.  And  greater  explicitness  can 
be  introduced  by  indicating  the  shrinkages,  perhaps  as 
f  oJlows : 

FORM  80. 
Dr.  Balance  Sheet.  Cr. 


Property 

Original  Cost  .  .  $10,000 

Less  Shrinkage.      9,000 


Miscellaneous  Assets . . , 


$1,000 
15,000 

$16,000 


Capital  Outstand- 
ing  $22,000 

Less  Shrinkage, 

per  Contra 9,000 


$13,000 
Profit  and  Loss 3,000 

$16,000 


The  matter  is  simple — all  that  is  needed  is  clearness 
and  honesty— and  the  facts  can  be  presented  in  various 
satisfactory  forms.  The  undesirability  of  paying  divi- 
dends while  capital  is  diminished  has  nothing  to  do  with 
the  necessity  of  truthfully  showing  what  has  taken  place. 
That  such  is  seldom  or  never  done  is  perhaps  unfortu- 
nately true,  but  it  does  not  depend  altogether  on  the  much 
criticised  decisions  of  the  courts. 

The  rule  that  a  shrinkage  of  capital  should  be  shown 
in  the  Balance  Sheet  is,  perhaps,  to  be  modified  in  cases 
where  the  loss  is  incapable  of  exact,  or  even  approximate, 
estimation.  Thus  the  cost  of  an  oil  well  represents  wast- 
ing capital  which  logically  should  be  written  off  as  the  oil 
is  exhausted.  But  the  estimate  of  the  oil  supply  is  so 
much  a  matter  of  guesswork  that  it  may  be  better  to  retain 
the  known  cost,  without  attempting  any  estimate  of  the 
rate  of  exhaustion.  Accordingly  mining  enterprises  gen- 
erally make  no  allowance  for  exhaustion.  But  in  some 
cases,  of  which  the  Colorado  Fuel  and  Iron  Company  is 
an  instance,  regular  charges  are  made"  against  profits  for 


222  MODEKN   ACCOUNTING 

each  ton  mined.  The  idea  is,  of  course,  to  show  the  pres- 
ent actual  value.  Where  the  amount  of  shrinkage  is  known, 
it  must  appear  in  the  accounts.  But  where  the  accuracy  of 
a  valuation  is  specious,  where  the  only  ascertainable  value 
is  the  original  cost,  it  may  be  less  harmful  for  the  Balance 
Sheet  to  show  the  cost,  indicating  that  it  does  not  repre- 
sent the  present  value.  The  interested  persons  can  then 
make  their  own  allowances  for  shrinkage  of  capital  assets. 

There  are  a  few  questions  which  arise  regarding  the 
Credit  side  of  the  Profit  and  Loss  account,  that  is,  as  to 
whether  certain  increases  in  the  net  wealth  should  appear 
in  that  account.  Among  these  may  be  mentioned  the  re- 
ceipt of  premium  on  capital  stock.  It  is  evident  that  such 
receipts  are  in  no  sense  profits  arising  from  the  business, 
and  custom  is  opposed  to  crediting  them  to  Profit  and 
Loss,  although  by  the  dictum  of  Lord  Homer  in  Hoare  and 
Company  ( [1904]  2  Ch.  213)  they  may  legally  be  applied 
to  the  payment  of  dividends.  In  banks,  where  the  issue 
of  stock  at  a  high  premium  is  especially  frequent  it  is  cus- 
tomary to  credit  Surplus,  and  such  treatment  is  alto- 
gether to  be  approved. 

Premium  received  on  bonds  is  different  in  its  nature. 
Here  the  receipt  is  an  offset  for  high  interest  paid,  or  a 
bonus  received  because  of  exceptional  credit.  It  is  directly 
proportioned  to  the  time  that  the  bonds  run.  And  as  the 
annual  interest  is  charged  against  profit  during  each  year 
of  the  life  of  the  bond,  the  only  correct  method  is  to  credit 
as  an  offset  to  this  charge  a  proportionate  part  of  the  pre- 
mium received.  No  objection  would,  however,  be  made 
to  a  conservative  placing  of  the  entire  premium  in  some 
general  Keserve  account,  and,  of  course,  if  the  amount  re- 
ceived is  small,  it  would  be  hypercritical  to  demand  that  it 
be  minutely  divided  through  a  long  series  of  years. 

Premium  arising  from  the  reissue  of  stock  forfeited 
because  of  nonpayment  of  assessments  should  be  treated 


PKOFITS  223 

as  any  other  premium  on  stock,  that  is,  carried  to  Reserve 
or  Surplus  rather  than  to  the  current  Profit  and  Loss  ac- 
count. But  the  objection  to  crediting  the  excess  to  profits 
is  based  on  accounting  principles,  not  on  law  (Gratz  v. 
Redd,  4  B.  Mon.  Ky.  178). 

More  interesting  is  the  broader  question  as  to  whether 
appreciation  in  the  value  of  the  so-called  capital  assets  is 
divisible  as  profits.  This  is  clearly  the  reverse  of  the  ques- 
tion previously  discussed.  There  the  concept  of  a  loss  of 
capital  as  something  distinct  from  a  loss  of  revenue  was 
introduced.  The  reverse,  that  there  is  possible  an  increase 
of  capital  which  is  not  profit  involves  the  same  principle. 
Discussion  has  been  somewhat  confused  by  not  clearly  dis- 
tinguishing between  an  appreciation  which  has  been  real- 
ized, and  one  which  is  estimated  only.  But  where  the  gain 
is  actually  realized,  it  certainly  may  be  credited  to  Profits, 
although  if  the  gain  be  exceptional  it  would  conservatively 
be  placed  to  some  Surplus  or  Reserve  account.  This  doubt 
less  is  inconsistent  with  the  doctrine  of  Lee  v.  Neuchatel 
Asphalte  Company.  Indeed  one  argument  given  by  the 
court  in  favor  of  excluding  the  shrinkage  in  value  of  cap 
ital  assets  was  that  a  contrary  rule  would  imply  that  divi- 
dends might  be  paid  out  of  the  increase  in  value  of  capital, 
which  was  said  to  be  "  contrary  to  all  practice  and  to 
principle."  • 

But  this  very  doctrine,  in  so  far  as  it  relates  to  a  real- 
ized gain,  was  soon  fully  admitted  in  Lubbock  v .  British 
Bank  ( [1892]  2  Ch.  198)  which  has  since  been  followed 
in  various  decisions.  However  successfully  the  courts  at- 
tempt to  distinguish  between  capital  and  revenue,  or  even 
between  a  shrinkage  of  capital  and  a  loss  of  revenue,  there 
is  now  no  effort  to  differentiate  between  a  realized  gain 
due  to  the  appreciation  of  capital  assets  and  other  income.1 

1  Some  exceptions  to  this  may  be  found  in  case  of  the  final  distribu- 
tion of  assets  of  liquidated  concerns. 


224  MODERN   ACCOUNTING 

More  delicate  is  the  question  of  unrealized  profits.  In 
the  discussion  of  the  Inventory  in  Chapter  IV,  it  was 
shown  that  mere  fluctuations  in  value  may  be  disregarded ; 
and  that  even  permanent  appreciation,  if  it  is  of  assets 
whose  nature  is  such  that  the  gain  cannot  be  realized  by 
the  going  concern,  should  similarly  be  left  out  of  account. 
Thus  an  estimated  appreciation  in  the  value  of  the  factory 
site  should  be  left  out  of  account,  even  though  the  estima- 
tion have  every  element  of  certainty.  The  prohibition  of 
thus  marking  up  assets  precludes  any  credit  in  the  Profit 
and  Loss  account,  or  elsewhere.  But  where  the  apprecia- 
tion is  in  merchandise,  or  in  what  are  commonly  called 
circulating  assets,  there  is  less  uniformity.  It  has  been 
seen  that  German  law  distinctly  prohibits  the  taking  of 
profits  due  to  appreciation  of  unsold  merchandise,  even 
where  the  increased  value  is  evidenced  by  quoted  prices  in 
produce  or  stock  exchanges.  But  on  the  other  hand  Aus- 
trian law  authorizes  the  taking  of  such  profits.  A  leading 
Massachusetts  case  held:  "  The  profit  and  loss  of  trade 
in  merchandise  is  not  confined  to  that  which  results  from 
sales.  Depreciation  or  advance  in  value  of  the  stock  un- 
sold must  also  be  taken  into  account.  (Meserve  v.  An- 
drews, 106  Mass.,  419  (1871).)  But  in  this  case  there  had 
been  a  loss  by  fire  so  that  the  ruling  regarding  an  advance 
in  value  is  less  authoritative.  Furthermore,  the  case  re- 
ferred to  a  final  settlement  or  dissolution  of  partnership, 
which  differs  in  important  particulars  from  the  status  of  a 
going  concern.  The  opinion  of  accountants,  always  siding 
toward  wise  conservatism,  is  well-nigh  unanimous  against 
taking  profits  on  unsold  goods. 

But  the  difficulties  are  not  yet  all  settled.  Frequently 
goods  have  actually  been  sold  at  an  advance,  but  the  pay- 
ment for  them  has  not  yet  been  received.  Or  interest  on 
loans  and  investments  may  have  accrued,  but  either  is  not 
yet  matured,  or  if  matured,  is  not  yet  paid.  Had  cash 


PKOFITS  225 

been  received  these  would  most  obviously  be  counted  as 
profit,  but  objection  has  at  times  been  made  to  including 
in  profit  anything  not  received  in  cash.  From  the  maze  of 
discordant  decisions  the  puzzled  accountant  seeks  in  vain 
for  a  safe  guide.  The  earlier  English  cases  were  satisfac- 
torily clear,  especially  Stringer's  case  (L.  R.  4  Ch.  475 
[]869])  where  it  was  held  that  cash  need  not  be  in  hand, 
and  that  the  obligations  of  the  Confederate  government 
honestly  estimated  as  good,  were  a  correct  basis  for  deter- 
mining profits  available  for  dividends.  This  decision  has 
long  been  accepted  as  authority,  yet  an  entirely  different 
doctrine  was  enunciated  so  late  as  1902  in  Badham  v. 
Williams,  in  which  Justice  Kekewich  gave  an  opinion  so 
remarkable  as  to  deserve  quoting  at  some  length:  "  If  it 
is  a  mere  question  what  were  the  profits  made  in  a  par- 
ticular year,  it  seems  to  me  that  the  duty  is  to  ascertain 
what  cash  has  been  received  and  what  cash  has  been  ex- 
pended, and,  if  that  is  fairly  done,  you  know  the  profits  of 
the  year.  If  there  is  a  large  outstanding  liability  which 
cannot  be  settled,  the  partners  will  estimate  that,  and  it 
will  not  be  considered  as  part  of  the  profits.  If  there  is 
a  large  outstanding  possible  loss,  and  there  is  a  large  sum 
due  to  a  client,  then  you  would  provide  for  that.  But  in 
ascertaining  what  is  really  actually  divisible  for  the  year 
fairly,  you  take  the  cash  account  as  it  stands.  ..." 

"  A  merchant  in  London  consigned  a  cargo  to  some 
foreign  port  for  sale  in  1901.  Suppose  the  payment  is 
made  by  bill  perhaps  at  six  or  three  months,  it  may  run 
into  1902.  Now,  are  they  to  treat  that  as  concluded  in 
1901  and  consider  that  business  as  attributable  entirely 
to  1901  when  the  bill  may  not  be  met  at  maturity?  Are 
they  to  consider  those  as  so  much  cash  for  the  purposes  of 
that  business  ?  It  seems  to  me  that  that  would  be  entirely 
wrong  in  the  absence  of  a  special  agreement.  For  the  pur- 
poses of  the  balance  sheet,  no  doubt,  they  would  estimate 


226  MODERN   ACCOUNTING 

that  there  is  an  outstanding  asset  which  they  hope  to  real- 
ize; but  for  the  purpose  of  ascertaining  the  profit  and 
loss — that  is  to  say,  what  is  to  be  divided  it  seems  to  me 
that  they  must  consider  only  what  they  have  received,  b£- 
cause  those  bills  will  only  come  in  when  met  at  maturity 
in  1902."  (86,  L.  T.  R.  191.) 

In  the  United  States  the  courts  have  more  generally 
considered  that  only  actual  receipts  and  payments  are 
proper  entries  in  the  Profit  and  Loss  account.  It  is  true 
that  the  United  States  Supreme  Court  in  1893  (Reagan 
v.  Farmers  Loan  &  Trust  Co.,  154  U.  S.,  362)  held  that 
accrued  interest  payable  should  be  considered,  but  that  did 
not  cover  the  question  of  interest  receivable.  As  has  been 
seen  the  same  court  in  Eyster  v.  Centennial  Board  of  Fi- 
nance identified  profits  with  net  receipts.  In  California, 
moreover,  it  has  been  specifically  held  in  People  v.  San 
Francisco  Savings  Union  that  interest  accrued,  even  on 
United  States  bonds,  cannot  be  considered  in  determining 
profit.  In  the  course  of  the  decision,  which  is  well  worth 
reading  in  full,  the  court  says:  "It  is  not  easy  to  com- 
prehend how  profits  or  surplus  profits  can  consist  of  earn- 
ings never  yet  received.  The  term  imports  an  excess  of 
receipts  over  expenditures  and  without  receipts  there  can- 
not properly  be  said  to  be  profits.  Money  earned  as  in- 
terest, however  well  secured  or  certain  to  be  eventually 
paid  .  .  .  does  not  constitute  surplus  profits  within  the 
meaning  of  the  statute."  (72  Cal.  19.9  (1887).) 

In  New  Jersey  and  Missouri,  on  the  contrary,  it  has 
been  held  that  profits  are  not  necessarily  limited  to  money 
received.  (Jones  v.  Davis,  48  N.  J.  Eq.  493  (1891).  Slay- 
den  v.  Coal  Co.  25  Mo.  Ap.,  439  (1887).) 

Much  of  the  confusion  is  doubtless  due  to  a  mere  dif- 
ference in  terminology,  and  oftentimes  the  term  ' '  prof- 
its ' '  in  legal  use  means  ' '  profits  available  for  dividends. '  * 
The  courts  may  well  place  certain  restrictions  on  the  pay- 


PKOFITS  227 

ment  of  dividends  which  would  not  at  all  correspond  with 
the  accountant's  limitations  of  the  concept  of  profits.  In- 
deed, this  is  in  many  cases  done  by  statute;  as  is  true  in 
a  number  of  the  Spanish  American  Republics,  which  pre- 
scribe that  only  liquid  profits  may  be  paid  as  dividends.  It 
may  be  accepted  that  it  is  incorrect  to  base  a  dividend  on 
unrealized  profits,  or  indeed  that  an  unrealized  gain  is 
"  not  profit,  but  the  hope  of  profit."  There  is  good  busi- 
ness conservatism  in  the  argumen^of  Dupin,  "  One  does 
not  divide  hopes,  however  well-founded ;  one  does  not  di- 
vide a  phrase,  but  money.  A  dividend  before  going  out 
of  the  treasury  of  the  company,  ought  first  to  have  come 
into  it."1 

But  the  distinction  between  unrealized  and  realized 
profits  is  by  no  means  the  same  as  that  between  profits 
which  have  been  received  in  cash  and  those  otherwise  rep- 
resented. Profits  are  in  fact  realized  when  once  the  trans- 
action is  completed.  If  it  is  a  sale  of  merchandise  the 
selling  price  includes  both  profit  and  a  portion  of  the  cap- 
ital. It  matters  not  whether  this  price  is  represented  by 
cash,  or  by  the  note  of  the  purchaser,  or  by  other  assets 
received  in  payment,  provided,  of  course,  that  there  is  no 
valid  doubt  as  to  their  real  value.  If  the  claim  against  the 
purchaser  is, good,  profit  has  been  realized;  if  the  claim 
is  not  good,  there  is  not  only  an  absence  of  profit  but  a 
further  loss  representing  the  original  investment.  To  rec- 
ognize part  of  this  sum  as  good  and  to  discriminate  against 
the  other  larger  part  is  clearly  illogical.  Illogical  is  the 
attitude  of  the  California  court  that  the  claim  for  one  per 
cent,  interest  against  the  government  may  not  be  counted 
good,  while  the  hundred  per  cent,  of  principal  still  stands 
among  the  assets  at  its  full  value. 

The  whole  discussion  of  the  form  in  which  profits  are 
received  involves  the  frequently  recurring  confusion  to 

1  Quoted  in  Bastide:  De»  Dividends  fictifs,  p.  36 


228  MODERN   ACCOUNTING 

which  reference  has  been  made,  between  assets  and  the 
credit  side  of  the  Balance  Sheet.  The  assets  cannot  be  dis- 
tinguished as  being  this  capital  and  that  profit.  All  the 
assets  together  equal  capital  and  profits.  Hence  as  Mr. 
Ernest  Cooper  has  pointed  out  the  question  as  to  whether 
the  profits  are  liquid  or  not  cannot  legitimately  be  raised.1 

Furthermore,  it  is  quite  possible  for  a  company  to  pay 
dividends  even  though  it  has  no  cash.  Thus  the  Dutch 
East  India  Company  regularly  paid  part  of  its  dividends 
in  spices.  A  more  modern  instance  is  -the  dividend  de- 
clared in  1907  by  the  Atlantic  Coast  Line  and  paid  by  its 
own  certificates  of  deposit,  then  lying  in  the  treasury. 

But  it  certainly  would  be  unwise  for  a  court  to  compel 
the  payment  of  a  dividend  in  the  absence  of  liquid  assets 
and  the  decisions  cited  are  based  on  this  practical  objection 
rather  than  on  any  recognized  principle  that  profits  exist 
only  when  in  cash.  And  even  unliquidated  earnings  have 
at  times  been  made  the  basis  of  compulsory  dividends,  as 
in  the  case  of  the  charter  of  the  Prussian  See-Handlungs- 
Gesellschaft,  which  prescribed  the  issue  of  scrip  where 
cash  was  not  available.  In  charity  to  the  courts  the  de- 
cisions cited  are  to  be  interpreted  not  as  meaning  that 
only  cash  earnings  are  profits,  but  that  the  courts  will 
not  compel  a  company  to  pay  a  dividend  when  the  absence 
of  cash  or  its  equivalent  might  compel  a  perhaps  disad- 
vantageous borrowing,  or  a  loss  due  to  a  forced  sale  of 
some  of  the  assets. 

Other  decisions  of  the  courts  are  rational  only  in  a 
similar  loose  interpretation.  Thus  it  has  been  held :  ' '  All 
the  debts  (other  than  funded  debts)  .  .  .  are  debts  to  be 
paid  before  the  profits  can  be  ascertained."  (Corry  v. 
Londonderry  &  Enniskillen  Ry.  Co.,  29  Beaven  263 
[3860]),  and  while  it  was  later  said  to  be  a  "  curious 
theory  .  .  .  that  there  never  can  be  any  available  income 

'  Accountant,  XIV.  p.  74ft 


PROFITS  229 

or  any  profits  as  long  as  there  is  a  debt  remaining  unpaid  ' ' 
(Mills  v.  No.  Ry.  of  Buenos  Ayres  Co.  5  Ch.  App.  621 
(1870))  the  same  theory  has  more  than  once  been  openly 
propounded  in  American  courts.  Even  the  United  States 
Supreme  Court  held  that:  "  Net  earnings  are  what  is 
left  after  paying  current  expenses  and  interest  on  debt 
and  everything  else  the  company  is  liable  to  pay  '*:  (War- 
ren v.  King,  108  U.  S.,  389,  398  [1882])  and  the  same 
high  authority  later  defines  profits  as  denoting:  "  What 
remain  after  defraying  every  expense,  including  loans  fall- 
ing due,  as  well  as  the  interest  on  such  loans."  (Mobile, 
etc.,  R.  R.  v.  Tenn.,  153  U.  S.,  486  (1894).) 

Taken  literally  the  notion  that  debts  must  be  paid  be- 
fore profits  are  ascertained  is  to  the  accountant  both  ' '  cu- 
rious "  and  "  absurd."  But  that  the  court  should  refuse 
to  order  a  dividend,  when  the  depletion  of  the  treasury 
might  make  an  impending  debt  disastrous  is  perfectly  rea- 
sonable. It  is  Only  to  be  regretted  that  in  taking  a  con- 
servative position,  it  should  be  done  at  the  cost  of  confused 
terminology  and  questionable  theorems. 

The  limitation  of  profits  to  cash  receipts  is  closely  con- 
nected with  the  question  of  borrowing  funds  with  which 
to  pay  dividends.  If  profits  have  really  been  earned,  the 
replenishment  of  the  cash  account  through  borrowing  re- 
moves any  objections  which  the  accountant  might  have 
to  the  declaration  of  a  dividend.  But  Lord  Justice  Lind- 
ley  characterized  the  payment  of  dividends  with  borrowed 
money  as  being  "  as  unjustifiable  in  point  of  law  as  it 
would  be  reckless  and  blameworthy  in  the  eyes  of  business 
men."  (Verner  v.  General  &  Commercial  Trust  [1894] 
2  Ch.,  266.) 

Here  again  the  decisions  are  discordant.  In  some 
cases  the  payment  of  dividends  with  borrowed  funds  has 
been  condemned  (Davis  v.  Flagstaff  Silver  Mining  Co., 
2  Utah  74;  Belfast  &  Moosehead  Lake  Ry.  Co.  v.  Belfast, 


230  MODERN   ACCOUNTING 

77  Me.,  445  (1885)),  but  the  lucid  decision  in  Williams 
v.  Western  Union  Telegraph  Company  (93  N.  Y.  162 
(1883))  showed  that  where  the  surplus  had  been  invested 
in  the  plant,  the  company  "  could  borrow  money  on  the 
faith  of  it  and  divide  that  "  (p.  192). 

In  the  even  more  extreme  case,  where  the  Balance 
Sheet  showed  for  a  time  no  surplus  because  improvements 
had  been  charged  against  past  profits,  it  has  been  held 
legitimate  to  credit  back  to  revenue  such  expenditures, 
and  then  to  borrow  funds  so  as  to  distribute  the  surplus 
thus  reestablished.  This  was  clearly  brought  out  in  Excel- 
sior Water  and  Mining  Company  v.  Pierce,  where  the  ex- 
pense of  constructing  a  tunnel  was  charged  up  against 
profits.  Afterwards  the  company  borrowed  funds  repre- 
senting the  cost  of  the  tunnel  and  used  them  to  pay  divi- 
dends. The  court  said:  "  The  result  is  precisely  the  same 
as  if  the  money  had  been  borrowed  sooner  and  the  identi- 
cal money  borrowed  paid  out  on  the  tunnel.  Nothing  has 
been  accomplished  beyond  what  the  directors  had  a  right 
to  do,  and  surely  the  mode  in  which  it  has  been  done  can 
make  no  difference.  In  fact,  the  transaction  may  be  re- 
garded as  a  temporary  borrowing  from  the  dividend  fund 
of  the  sum  necessary  to  meet  an  immediate  demand,  with 
the  advantage  to  the  corporation  of  keeping  its  money  em- 
ployed and  saving  it  the  payment  of  interest."  (90  Cal. 
131  (1891).  )* 

The  accountant  cannot  disregard  the  decisions  of  the 
courts,  or  he  may  find  that  he  has  led  his  clients  into  an 
action  for  which  they  may  be  held  liable.  But  it  is  evident 
that  many  of  the  decisions  to  which  reference  has  been 
made  are  at  least,  on  the  face,  opposed  to  what  the  ac- 
countant considers  fundamental  principles  of  his  profes- 
sion. Some  of  these  contradictions  can  be  smoothed  over 

1  See  also  Mills  v.  Northern  Railway,  etc.  (L.  R.  5  Ch.  App.  621 
(1870).) 


PEOFITS  231 

by  recognizing  that  the  courts  and  the  accountants  are 
attaching  quite  different  meaning  to  the  technical  terms 
of  commerce.  Difficulty  may  be  avoided  by  the  accountant 
continuing  to  lean,  as  in  the  past  he  has  generally  done, 
toward  conservatism,  for  while  the  courts,  as  in  the  ques- 
tion of  loss  of  capital,  sometimes  permit,  they  never  compel 
an  excessive  estimate  of  profits.  But  for  a  more  perfect 
rationalization  of  the  legal  dicta  concerning  profits,  it 
will  probably  be  necessary  to  await  the  day  when  the 
growing  dignity  of  the  profession  of  accounting  shall  cause 
its  principles  to  permeate  the  ranks  of  bench  and  bar. 

BIBLIOGRAPHICAL   NOTE   TO   CHAPTERS   XI   AND  XII 

BOOKS 

BASTIDE,  J.     Des  dividends  fictifs.     Toulouse,  1903. 

BUCKLEY,  H.  B.     The  Law  and  Practice  Under  the  Companies 

Acts,  pp.  584-592.     Eighth  edition.     London,  1902. 
CHARPENTIER,  J.     Etude  juridique  sur  le  bilan  dans  les  societes 

par  actions.     Paris,  1906. 
CLARK,  W.  L.  and  MARSHALL,  W.  L.     A  Treatise  on  the  Law  of 

Private  Corporations,  pp.  518-520.     St.  Paul,  1901. 
COOK,  W.  W.     A  Treatise  on  the  Law  of  Corporations  Having  a 

Capital  Stock,  p.  546.     Fifth  edition.     Chicago,  1903. 
DALE,  B.     How  Are  the  Profits  for  the  Year  to  be  Ascertained? 

Second  edition.     London,  1897. 
DICKINSON,  A.  L.     The  Profits  of  a  Corporation.     New  York,  1904. 

(Published  also  in  the  Official  Record  of  the  International 

Congress  of  Public  Accountants  held  in  St.  Louis,  1904.)     [A 

brief  but  comprehensive  and  most  valuable  treatise.] 
DICKSEE,  L.  R.     Auditing.    American  edition,  pp.  232-250.     New 

York,  1905. 
PALMER,  F.  B.    Company  Precedents.    I.  737-768.    Eighth  edition. 

London,  1902-1903.      [Contains  an  extended  review  and  a 

criticism  of  the  English  decisions  in  the  Lee  series.] 
PIXLEY,    F.    W.     Auditors,    their    Duties    and    Responsibilities. 

I.    Chapter  XIII.    Ninth  edition.     London,  1906, 


232  MODERN    ACCOUNTING 


PERIODICALS 

Are  the  Decisions  of  the  Courts  Respecting  the  Distribution  of  the 
Profits  of  a  Limited  Company  Opposed  to  Sound  Commercial 
Finance?  Accountant,  XXIX,  80. 

COOPER,  E.  Chartered  Accountants  and  the  Profit  Question. 
Ibid.  XX,  1033.  [See  also  editorial  discussion,  pp.  1073, 1088, 
119.] 

DAWSON,  S.  S.    Capital  and  Divisible  Profits.    Ibid.  XXIX,  119. 

Divisible  Profits  of  Companies.    A  Plea  for  Fuller  Parliamentary 
Recognition  of  Double  Accounting.     Ibid.  XXVUL;  417. 
[Argues  that  losses  of  fixed  capital  should  be  excluded  from 
the  accounts.] 

JAMES,  A.  The  Divisible  Profits  of  Companies.  Ibid.,  XXVIII, 
285. 

WELTON,  T.  A.  On  the  Profits  of  Companies  Available  for  Distribu- 
tion. Ibid.,  XIV,  677. 

For  a  discussion  of  the  correct  method  of  exhibiting  capital 

losses,  see: 
KEEN,  F.  M.     The  Balance  Sheet  of  a  Limited  Company.     Ibid., 

XXIV,  399. 

The  Reduction  of  a  Company's  Capital.     Accountant,  XXVI,  867. 
VAVASSEUR,  A.     Traite  des  societes  civiles  et  commerciales.    §  649. 

Paris,  1897. 


CHAPTER    XIII 

SURPLUS   AND   RESERVES 

IN  the  accounts  of  individual  traders  the  Profit  and 
Loss  account  is,  at  stated  intervals,  closed  out,  and  the 
balance  is  carried  to  the  credit  of  the  proprietor's  Capital 
account.  Profit  and  Loss  is  thus  in  practice,  as  well  as 
in  theory,  a  mere  temporary  subdivision  of  the  main  Pro- 
prietorship account,  and  at  the  close  of  the  year  is  indis- 
tinguishably  merged  with  the  latter.  In  corporation  ac- 
counting it  is  necessary  to  keep  the  accretions  of  wealth 
separate  from  the  original  capital  contributions.  Never- 
theless there  is  customarily  a  closing  of  the  books,  and  an 
apportionment  of  the  annual  profits  of  corporations  simi- 
lar to  that  which  takes  place  in  the  books  of  the  individual 
or  of  the  partnership.  At  such  a  time  a  part  of  the  profits 
are  normally  voted  as  dividends  and  immediately  pass  out 
of  the  control  of  the  corporation.  But  it  is  unusual  to  dis- 
tribute all  of  the  profits  earned  and  there  is  ordinarily 
further  action  by  the  directors  or  stockholders  deciding 
to  retain  part  of  the  profits.  The  profits  thus  reserved 
from  distribution  are  called  Surplus,  and  constitute  an 
addition  to  the  capital  of  the  concern,  practically  as  in  the 
partnership  the  profit  balance  is  retained  as  capital  by 
being  added  to  the  proprietor's  account. 

Even  in  corporation  accounting  the  similarity  between 
Capital  and  Surplus  is  sometimes  observed,  as  for  instance 
in  the  tabular  statements  prepared  by  the  Comptroller  of 
the  Currency,  in  which  Capital,  Surplus,  and  Undivided 
Profits  are  all  grouped  and  included  in  a  single  sum ;  and 

233 


234  MODERN  ACCOUNTING 

not  infrequently  in  published  balance  sheets  Capital  and 
Surplus  are  similarly  combined. 

While  there  are  legal  differences  in  the  treatment  of 
the  two  categories,  yet  from  the  view  point  of  accounting, 
a  Surplus  represents  capital  secured  by  reserving  profits, 
in  contradistinction  to  capital  contributed  directly  by  the 
stockholders. 

Some  technical  exceptions  are  to  be  found  to  the  state- 
ment that  a  Surplus  means  reserved  profits.  A  Surplus 
occasionally  is  established  by  a  corporation  de  novo,  before 
any  profits  have  accrued,  out  of  part  of  the  contributions 
made  directly  by  the  stockholders.  This  is  particularly 
the  case  in  organizing  banks  where  stock  is  often  sub- 
scribed for  at  a  premium.  It  is  questionable  whether  this 
premium  can  rightly  be  credited  to  the  Profit  and  Loss, 
or  Revenue  account.  Some  accountants  permit  this  and 
the  English  courts  have  declared  it  legal  (In  re  Hoare 
&  Co.  [1904]  2  Ch.  213).  But  statute  law  in  Germany, 
and  the  better  practice  both  in  England  and  the  United 
States,  hold  that  such  premiums  are  no  part  of  ordinary 
profits,  and  as  they  cannot  be  credited  directly  to  capital 
are  to  be  placed  in  a  special  Reserve  or  Surplus  account. 
Where  this  is  done  there  is  technically  no  reservation  of 
profits,  but  at  least  it  is  a  reservation  of  the  excess  above 
capital,  the  peculiarity  being  that  an  excess  over  capital, 
normally  caused  only  by  the  gain  of  profits,  is  in  this  case 
created  by  a  contribution  of  the  stockholders. 

Other  circumstances  in  which  a  Surplus  is  created 
otherwise  than  by  accumulating  profits  are :  where  the 
stock  of  a  company  is  reduced  without  full  return  to  the 
stockholders  of  the  par  value;  where  stock  is  bought  in 
the  market  at  less  than  its  face  value;  and  less  clearly 
where  bonds  are  similarly  redeemed.  The  payment  some- 
times made  by  stockholders  in  return  for  having  their 
holdings  given  the  privileges  of  preferred  stock,  or  other 


SURPLUS    AND   RESERVES 


235 


similar  advantages,  likewise  properly  gives  rise  to  a  Sur- 
plus which  strictly  speaking  is  not  profit.  Occasionally, 
too,  stockholders  make  a  voluntary  contribution,  generally 
of  stock,  for  the  purpose  of  providing  means  for  raising 
cash  for  working  expenses,  which  again  creates  a  Surplus 
not  derived  from  profits.  In  all  these  cases  it  would  not 
be  illegal,  except  when  statute  law  distinctly  prohibits,  as 
is  the  case  in  Germany,  to  treat  these  receipts  as  profits 
available  for  dividends,  and  they  may  therefore  all  be 
regarded  as  exceptions  to  the  general  statement  that  a 
Surplus  or  Reserve  is  a  portion  of  profits  withheld  from 
distribution. 

Accounting  nomenclature,  however,  is  so  vague,  that 
it  is  not  always  easy  nor  possible  to  determine  from  a  Bal- 
ance Sheet  whether  certain  items  represent  an  actual  res- 
ervation of  profits  or  whether  they  are  merely  Valuation 
Accounts;  that  is,  accounts  indicating  that  a  deduction 
must  be  made  from  the  book  value  of  the  assets.  This 
may  be  illustrated  by  taking  a  company  whose  books,  at 
the  end  of  a  year,  make  the  following  showing: 


Dr. 


FORM  81. 
Trial  Balance. 


Cr. 


Plant  at  cost $50,000 

Accounts  receivable 50,000 

Expenses 50,000 

Miscellaneous  Assets ....  25,000 

$175,000 


Capital $100,000 

Sales 75,000 


$175,000 


This  shows  an  apparent  gain  of  $25,000,  but  no  allowance 
has  as  yet  been  made  for  depreciation,  without  which  prof- 
its cannot  be  determined.  Assuming  the  depreciation  to 
be  $5,000  the  Balance  Sheet  may  show : 


236 


MODERN   ACCOUNTING 


Dr. 


FORM  82. 
Balance  Sheet. 


Cr. 


Plant  at  cost $50,000 

Accounts  receivable 50,000 

Miscellaneous  Assets. . . .      25,000 

$125,000 


Capital $100,000 

Depreciation' 5,000 

Profits 20,000 

$125,000 


The  directors  or  stockholders  decide  that  business  is  so 
profitable  that  it  will  be  desirable  to  extend  the  plant 
within  a  few  years,  and  in  preparation  therefor  vote  to 
withhold  $5,000  of  the  profits  as  the  beginning  of  a  fund 
with  which  to  make  the  expected  extensions;  and  in  order 
to  be  on  the  safe  side  they  vote  to  reserve  $1,000  to  cover 
any  possible  future  loss  which  may  occur  when  attempt 
is  made  to  realize  on  the  accounts  receivable.  They  fur- 
thermore decide  to  hold  $5,000  as  a  Surplus,  or  permanent 
addition  to  the  capital  resources,  and  vote  a  dividend  of 
$8,000.  This  leaves  an  unappropriated  balance  of  $1,000. 
The  Balance  Sheet  then  reads  as  follows: 


Dr. 


FORM  83. 
Balance  Sheet. 


Cr. 


Plant  at  cost 

Accounts  receivable. . . 
Miscellaneous  Assets.. . 


$50,000 
50,000 
25,000 


$125,000 


(1)  Capital $100,000 

(2)  Depreciation  Fund. .  5,000 

(3)  Reserve    for    exten- 

sions    5,0(50 

(4)  "Reserve"    for   Bad 

Debts 1,000 

(5)  Dividends  declared..  8,000 

(6)  Surplus 5,000 

(7)  Balance     of     Undi- 

vided Profits 1,000 


$125,000 


1  The  depreciation  account  is  purposely  left  on  the  credit  side  instead 
of  being  subtracted  from  the  valuation  of  the  plant  in  order  to  emphasize 
the  distinction  made  below. 


SUKPLUS  AND  EESERVES        237 

The  terms  here  used  are  customary  ones,  but  usage  is 
not  absolutely  fixed  and  other  titles  are  frequently  met  in 
Balance  Sheets.  So  far  as  it  is  possible  to  give  a  fixed 
definition  the  differentiation  in  the  terms  used  is  about 
as  follows: 

Surplus  indicates  a  portion  of  the  profits  withheld 
from  distribution  for  the  purpose  of  establishing  a  per- 
manent addition  to  the  effective  capital  of  the  concern. 
It  does  not  imply  any  specific  use  to  which  it  is  to  be  put 
and  is  perhaps  the  most  comprehensive  of  all  the  terms 
employed  to  designate  reserved  profits. 

Reserve  generally  contains  the  idea  of  some  special  pur- 
pose for  which  the  reservation  is  made.  This  is,  however, 
not  uniformly  so,  as  there  are  frequently  found  certain 
Reserves  made  for  some  specific  purpose,  and  a  more  gen- 
eral Reserve,  which  would  correspond  exactly  to  "  Sur- 
plus "  as  used  above.  By  some  Reserve  is  differentiated 
from  Surplus  by  implying  some  peculiar  investment,  as 
is  shown  later,  but  this  is  not  a  generally  accepted  con- 
vention. In  Germany  Reserve  is  the  common  term,  there 
being  no  equivalent  to  Surplus. 

Undivided  Profits  merely  indicates,  as  the  name  sug- 
gests, a  portion  of  the  profits  on  which  no  specific  action 
was  taken.  But  the  fact  that  it  was  not  voted  as  a  divi- 
dend does  constitute  it,  in  fact  though  not  in  name,  a  Sur- 
plus Reserve.  The  reason  for  differentiating  is  the  unwill- 
ingness to  distribute  so  closely  the  profits  as  to  run  the 
risk  of  having  a  Debit  balance  appear  in  the  Profit  and 
Loss  account. 

Other  titles  are  used.  Rest,  in  England,  is  the  equiva- 
lent of  Surplus  or  of  Reserve  (in  the  general  sense)  ;  Re- 
serve Fund  is  used,  either  as  synonymous  with,  or  with 
varying  differentiations  from,  Reserve;  Specific  Reserves 
are  often  called  by  some  distinguishing  title,  as,  for  in- 
stance, Renewal  Fund,  Sinking  Fund,  etc. ;  and  in  Ameri- 


238  MODERN   ACCOUNTING 

can  Railroad  practice  the  undivided  profits  appear  as  Bal- 
ance of  Income  Account. 

In  examining  a  Balance  Sheet,  such  as  is  shown  above, 
the  most  important  thing  is  clearly  to  distinguish  between 
the  items,  of  which  Depreciation  Fund  (2)  is  the  type, 
and  those  of  which  Reserve  for  Extension  (3)  is  the  type. 
This  is  all  the  more  difficult  in  practice  because  the  titles 
used  are  frequently  more  similar  than  those  given  above, 
for  (2)  is  often  called  Reserve  for  depreciation,  or  Reserve 
Fund  for  Depreciation,  and  (3)  may  simply  be  called  Re- 
serve or  Reserve  Fund.  Yet  the  real  distinction  between 
them  is  radical,  and  the  use  of  the  term  Reserve  in  the 
former  sense,  while  not  uncommon  in  American  account- 
ing, is  open  to  serious  criticism.  The  Depreciation  Fund 
does  not  represent  profits  at  all ;  it  does  not  indicate  owner- 
ship of  any  net  wealth  in  addition  to  that  represented  by 
the  capital  stock.  On  the  contrary,  it  is  a  Valuation  Ac- 
count indicating  that  a  deduction  must  be  made  from  the 
value  of  assets  given  on  the  Debit  side  of  the  Balance 
Sheet.  The  Reserve  for  Extension  (3)  is,  however,  a  part 
of  the  profits;  it  does  represent  an  addition  to  the  orig- 
inal net  wealth  shown  in  the  Capital  account;  it  shows 
that  assets  have  incre'ased.  To  distinguish  between  Valu- 
ation Accounts  and  Reserves  proper  is  therefore  no  less 
important  than  it  is  difficult. 

Item  (4),  "  Reserve  for  bad  debts  "  is  perhaps  even 
more  difficult  to  classify.  There  has  been  no  wear  and  tear. 
No  one  of  the  accounts  is  known  to  be  bad;  no  single  one 
of  them  is  even  suspected.  Each  is  carried  on  the  books 
at  its  full  value,  and  perhaps  no  one  of  them  would  be 
sold  at  a  discount  of  two  per  cent.  Yet  ordinary  common 
sense  and  business  experience  show  that  a  loss  is  likely 
to  occur,  and  a  Reserve  is  provided  so  that  if  a  loss  should 
take  place  it  need  not  be  charged  against  the  current  prof- 
its. From  the  outside  it  is  impossible  to  say  whether  this 


SURPLUS  AND  RESERVES        239 

is  nearer  akin  to  depreciation  or  to  a  reservation  of  prof- 
its. If  under  the  law  of  probabilities  the  loss  is  practically 
certain  to  take  place,  it  is  logically  a  depreciation  for  an 
unrealized  but  existing  loss.  If  the  creation  of  the  Reserve 
was  based  on  a  minimum  certainty  and  a  maximum  of 
prudence  it  represents  a  reservation  of  profits.  The  bal- 
ance left  standing  to  the  credit  of  Undivided  Profits  is 
logically  and  legally  a  Reserve,  even  though  not  techni- 
cally so  called.  Profits  which  might  have  been  distributed 
were  not  voted  as  dividends  and  are,  ipso  facto,  held  as 
a  reserve.  The  only  difference  is  a  psychologic  one,  and 
consists  in  the  fact  that  the  directors  have  apparently  not 
expressed  so  definite  an  intention  of  permanently  holding 
the  balance,  as  they  have  done  in  regard  to  the  Reserve 
for  Extensions  and  Reserve  for  Bad  Debts. 

A  Surplus,  by  whatever  name  it  may  be  called,  repre- 
senting additional  capital  (normally  derived  from  profits) 
the  purposes  for  which  it  is  created  may  be  any  of  those 
for  which  capital  is  needed,  or  it  may  be  used,  as  profits 
ordinarily  are  used,  to  provide  means  for  paying  divi- 
dends. More  specifically  reserves  are  created: 

(1)  To  provide  a  permanent  increase  of  capital 

(a)   As  an  additional  guaranty  to  creditors 
(6)   To   provide   for   extension  of  its  fixed   or 
other  capital  assets. 

(2)  To  provide  an  additional  capital  which  can  be  used 

to  cover  unusual  losses  or  to  provide  for 
other  emergencies  without  encroaching  on 
the  nominal  capital,  and 

(3)  To  provide  for  equalizing  dividends  by  retaining 

part  of  one  year's  profit  to  be  used  to 
make  up  scanty  profits  for  other  years. 

1.  The  provision  of  additional  capital  as  further  pro- 
tection to  creditors  is  frequently  specifically  required  by 


240  MODERN   ACCOUNTING 

statute.  In  this  country  the  best  example  is  found  in  the 
National  Bank  Act,  which  requires  that  one  tenth  of  the 
annual  profits  must  be  retained  until  a  Surplus  amount- 
ing to  twenty  per  cent,  of  the  capital  stock  is  accumulated. 
More  comprehensive  are  the  laws  of  Germany  and  France, 
which  require  all  corporations  to  reserve  a  percentage  of 
the  profits,  and  in  addition  certain  particular  receipts, 
as,  for  example,  premium  on  stock.  In  both  these  cases 
the  purpose  of  the  law  presumably  is  to  furnish  additional 
security  to  creditors  of  the  corporations  concerned.  An- 
other example  is  the  establishment  of  a  Sinking  Fund  to 
pay  off  a  bonded  debt,  which  according  to  current  prac- 
tice in  the  United  States  is,  as  is  shown  below,  a  Reserve  to 
protect  the  creditors. 

The  extension  of  the  business  through  reserves  is  of 
frequent  occurrence.  A  most  striking  instance  is  the 
Chemical  National  Bank  which,  with  $300,000  capital 
stock,  accumulated  a  surplus  of  $6,000,000.  But  the  prac- 
tice is  of  much  older  origin,  for  the  Bank  of  St.  Ambrose, 
established  in  Milan  in  1593,  made  a  practice  of  distribu- 
ting only  half  its  profits  and  accumulated  a  large  surplus ; 
and  the  early  trading  companies  similarly  divided  only 
a  fraction  of  their  profits.  Similarly  many  railroads  and 
industrial  corporations  show  reserves  which  make  a  very 
appreciable  addition  to  their  capital.  An  instance  which 
has  caused  considerable  discussion  is  the  "Wells-Fargo  Ex- 
press Company  with  $8,000,000  capital  and  over  $16,000,- 
000  surplus.  In  foreign  countries  the  accumulation  of 
permanent  reserves  is  an  accepted  practice — the  average 
reserve  of  all  Austrian  corporations  being  over  27  per 
cent,  of  the  capital,  while  that  of  the  savings  banks  is 
over  105  per  cent. 

2.  The  second  class  of  Reserves  is  that  created  not  to 
provide  for  a  general  extension  of  the  enterprise,  but  to 
prevent  its  curtailment  by  providing  a  fund  to  be  used  in 


SURPLUS  AND  RESERVES        241 

special  emergencies.  A  clear  case  is  a  Renewal  Fund  cre- 
ated by  a  steamship  company  to  be  used  to  replace  ves- 
sels lost  at  sea.  But  more  general  aims  may  be  in  view, 
such  as  the  provision  against  any  unseen  loss,  whether 
caused  by  bad  debts,  by  slack  business  due  to  hard  times, 
or  by  any  of  the  countless  dangers  which  beset  the  course 
of  business  enterprise.  Because  of  such  a  reserve  the  First 
National  Bank  of  Chicago  some  years  ago  was  able  to 
charge  off  at  one  stroke  a  million  dollars  of  its  notes  and 
bills,  whose  ultimate  payment  was  made  uncertain  as  the 
result  of  the  panic  of  1893.  Another  corporation  in  1903 
suffered  loss  to  its  property  by  the  hurricane  in  Jamaica, 
a  loss  surely  not  distinctly  anticipated,  yet  one  which  was 
most  conveniently  covered  by  a  previous  Surplus. 

Such  provision  against  unforeseen  emergencies  may 
perhaps  be  construed  as  one  form  of  a  protection  for  credi- 
tors, and  the  legal  reserves  mentioned  above  are  as  a  mat- 
ter of  fact  generally  used  to  cover  exceptional  losses.  But 
this  provision  inures  as  well  to  the  benefit  of  stockholders, 
and  in  many  cases  the  establishment  of  a  Reserve  for  emer- 
gencies is  inspired  by  regard  for  the  stockholder  rather 
than  for  the  creditor — if  indeed  the  two  interests  can  be 
separated.  Among  such  emergency  reserves  may  be  men- 
tioned a  "  Reserve  for  personal  injuries  "  of  a  coal  com- 
pany ;  a  ' '  Reserve  for  accidents  ' '  not  unreasonably  pro- 
vided by  a  manufacturer  of  powder;  and  an  "  Accident 
fund  "  of  a  street  railway  company. 

3.  The  final  type  of  Reserves  is  that  for  the  purpose  of 
equalizing  dividends.  Here  it  is  scarcely  correct  to  say, 
as  has  been  done  by  some  writers,  that  the  Reserve  creates 
an  addition  to  Capital,  for  Capital  does  not  provide  a  fund 
for  dividend  paying.  Here  the  Reserve  preserves  rather 
its  original  character  as  profits— profits  not  distributed 
during  the  current  year,  but  to  be  distributed  as  dividends 
in  future  years,  when  the  annual  profits  may  be  scant. 


242  MODERN   ACCOUNTING 

This  is  a  most  common  practice  of  which  many  instances 
are  found  in  American  corporation  finance. 

The  different  purposes  enumerated  above  are  not  al- 
together distinct  or  mutually  exclusive,  the  provision  for 
unusual  losses,  for  instance,  being  at  the  same  time  an  ad- 
ditional guaranty  to  the  creditor  and  a  means  for  equaliz- 
ing dividends. 

The  purpose  of  a  surplus  may  be  more  or  less  definitely 
limited  and  specialized.  Most  commonly,  indeed,  there  is 
only  a  single  Reserve  created  which  is  general  in  its  char- 
acter, and  may  be  used  for  any  of  the  purposes  enumer- 
ated. On  the  other  hand  the  purpose  may  be  strictly  lim- 
ited, as  for  instance  a  Reserve  for  erecting  a  particular 
building,  or  for  constructing  a  certain  bridge.  The  United 
States  Steel  Corporation,  for  instance,  as  shown  in  its  Bal- 
ance Sheet  (Form  29)  has  in  addition  to  its  several  Sink- 
ing Funds  no  less  than  eight  Reserves,  including  funds  for 
contemplated  appropriations,  for  authorized  appropria- 
tions and  for  the  specific  purpose  of  building  the  plant  at 
Gary,  Indiana.  The  Balance  Sheet  of  the  Atchison,  To- 
peka  and  Santa  Fe  Railway  (Form  27)  shows  almost 
equal  differentiation.  But  even  where  the  Reserve  is  a 
special  one  there  is  no  assurance  that  it  will  be  devoted  to 
the  purpose  for  which  it  was  created.  The  specific  labeling 
of  a  Reserve  is  at  best  merely  a  declaration  of  the  pres- 
ent intentions  of  the  existing  board  of  directors.  As  both 
intentions  and  boards  are  subject  to  change,  there  is  no 
guaranty  that  the  Reserve  will  be  used  for  the  indicated 
purpose.  Continuity  may,  however,  in  some  cases  be  se- 
cured by  pledging  certain  funds  representing  the  reserve, 
as  for  instance  where  investments  representing  a  Sinking 
Fund  are  given  in  trust  to  sinking  fund  trustees  who  can 
use  them  only  for  the  purpose  of  retiring  specified  bonds. 
A  compulsory  Reserve  is  also  to  a  limited  extent  preserved 
from  division.  In  Germany  the  uses  to  which  it  may  be 


SURPLUS   AND   RESERVES 


243 


applied  are  definitely  prescribed;  in  this  country  the  Sur- 
plus, compulsory  for  National  and  for  some  State  banks 
is  presumably  safe  from  being  used  to  pay  dividends.  But 
even  here  the  restriction  is  only  a  limited  one,  for  a  loss 
which  otherwise  might  have  prevented  dividends,  may  be 
charged  to  Surplus.  Thus  a  company  showing 


Dr. 


FORM  84. 
Balance  Sheet. 


Cr. 


Assets $615,000 


$615,000 


Capital $100,000 

Surplus 10,000 

Deposits 500,000 

Undivided  Profits 5,000 

$615,000 


suffers  an  unexpected  loss  of  $5,000  and  charges  this 
against  Undivided  Profits.  It  will  then  probably  not  be 
considered  in  a  position  to  pay  a  dividend.  But  by  charg- 
ing the  unusual  loss  against  Surplus,  there  results  the  fol- 
lowing : 


Dr. 


FORM  85. 
Balance  Sheet. 


Cr. 


Assets $610,000 


$610,000 


Capital $100,000 

Surplus 5,000 

Deposits 500,000 

Undivided  Profits 5,000 

$610,000 


a  showing  which  makes  the  legitimacy  of  a  dividend  un- 
questionable. 

Frequently  the  designation  given  to  a  Reserve  refers 
not  to  the  purpose  for  which  it  was  created,  but  to  the 
source  whence  the  surplus  came.    Thus  are  found  the  fol- 
17 


244  MODERN   ACCOUNTING 

lowing  items:  Premium  received  on  old  stock,  Stock  pur- 
chase surplus,  Real  estate  sales,  Royalties,  Surplus  from 
redemption  of  bonds,  etc.,  all  of  which  indicate  the  source 
rather  than  the  purpose  of  the  Reserve. 

A  Surplus  being  a  reservation  of  profits  must  be  rep- 
resented by  equivalent  assets.  It  is  the  increase  of  assets 
that  creates  all  profit,  and  necessarily  that  portion  of  the 
profits  reserved  from  distribution.  To  speak  of  a  Surplus 
without  equivalent  assets  is,  therefore,  self-contradictory. 
But  with  the  ambiguous  usage  of  the  term  Reserve  the 
question  often  arises  as  to  whether  it  represents  assets  or 
merely  signifies  the  depreciation  in  value  of  some  of  the 
assets.  Some  writers  have  even  demanded  that  the  term 
Reserve  should  never  be  used  unless  it  represent  not 
merely  the  existence  of  equivalent  assets,  but  that  certain 
specific  assets,  of  a  particular  character  have  been  set  aside 
to  cover  the  Reserve. 

Deferring  to  a  subsequent  paragraph  some  distinctions 
in  terminology  which  have  been  involved  in  this  contro- 
versy, it  may  here  be  inquired  whether  the  distinction 
between  a  Reserve  represented  by  specific  assets — a  spe- 
cially covered  Reserve  or  as  some  term  it  a  Reserve  Fund 
— and  one  not  so  represented  is  significant. 

The  primary  objection  to  the  claim  that  a  Reserve  on 
the  Credit  side  of  the  Balance  Sheet  must  be  represented 
or  covered  by  certain  specific  assets,  is  that  it  implies  a 
confusion  of  the  two  sides  of  the  Balance  Sheet,  of  Goods 
accounts  and  Proprietorship  accounts.  The  Debit  side 
of  the  Balance  Sheet  lists  certain  specific  Goods,  the  value 
of  which,  less  liabilities,  equals  the  sum  of  the  various 
Proprietorship  accounts;  but  there  is  ordinarily  no  spe- 
cific asset  corresponding  to  specific  Credits.  Bonds  may 
have  been  issued  to  purchase  plant,  preferred  stock  to  pur- 
chase present  Goodwill,  common  stock  to  represent  the  esti- 
mated additional  earning  power  of  the  consolidation,  but 


SURPLUS   AND   RESERVES  245 

the  Balance  Sheet  does  not  make  a  separate  equation  of 
these  three  pairs.  It  suffices  to  show  that  Plant  -j-  Good- 
will —  Preferred  stock  -|-  Common  stock  -f-  Bonds. 

It  is  true  that  the  equating  of  the  various  items  is  in 
part  secured  by  the  double  account  form  of  Balance  Sheet 
required  of  certain  English  Companies,  where  the  receipts 
from  Capital  Stock  and  Bonds  are  balanced  against  the 
more  permanent  investments.  There  is  also  a  comparison 
made,  though  not  a  definite  equation  between  various  sub- 
heads frequently  introduced  into  modern  Balance  Sheets, 
as  for  instance  between  Capital  Assets  and  Capital  Liabil- 
ities and  between  Current  Assets  and  Current  Liabilities. 
But  even  in  such  cases  there  is  no  real  equivalence  stated 
between  a  given  Credit  and  some  other  Debit  item.  The 
equivalence  of  the  Balance  Sheet  is  that  between  the  sum 
of  the  items  representing  proprietorship  and  liabilities 
and  the  sum  of  those  representing  assets.  The  groups  into 
which  these  assets  are  subdivided  and  the  various  subdi- 
visions into  which  Proprietorship  is  for  convenience 
divided,  are  divergent  systems  of  classification  and  should 
not  be  confused.  In  the  varied  shifting  of  form  which  con- 
tinually takes  place  in  the  assets,  an  original  correspond- 
ence between  certain  Credits  and  Debits  becomes  lost  and 
the  connection  can  no  longer  be  traced.  Undoubtedly 
every  depositor  and  stockholder  in  a  bank  contributed 
some  particular  money  or  other  asset  equivalent  to  his  de- 
posit or  his  subscription;  but  the  identity  is  lost  at  once 
upon  the  title  passing  to  the  bank  and  there  is  no  specific 
asset  representing  the  particular  claim  of  A  although, 
for  convenience,  there  may  be  a  comparison,  though  not 
a  balancing  of  the  items  of  Deposits  and  Cash  Reserve,  or 
of  Deposits  and  Discounts. 

Secondly,  the  setting  aside  of  a  specific  asset  does  not 
make  the  Reserve  any  more  secure,  any  more  available. 
For  instance,  a  Balance  Sheet  shows: 


246 


MODERN   ACCOUNTING 


Dr. 


FORM  86. 
Balance  Sheet. 


Cr. 


Miscellaneous  Assets. . . .  $120,000 
Investment  of  Reserve 

Fund 5,000 

$125,000 


Capital $100,000 

Debts 20,000 

Reserve  for  Extension. . .        5,000 

$125,000 


A  debt  becomes  due,  which  because  of  financial  stringency 
cannot  be  renewed  or  placed  elsewhere.  Unless  the  invest- 
ments of  the  Reserve  have  been  specifically  placed  in  trust, 
they  will  in  such  an  emergency  probably  be  sold  to  provide 
cash  to  pay  the  debt.  The  Balance  Sheet  becomes: 


Dr. 


FORM  87. 
Balance  Sheet. 


Cr. 


Miscellaneous  Assets $120,000 


$120,000 


Capital $100,000 

Debts 15,000 

Reserve  for  Extension. .  .        5,000 

$120,000 


The  specific  investment  has  not  made  the  Reserve  for  Ex- 
tension any  more  available  than  it  otherwise  would  have 
been,  and  the  Reserve  remains  despite  the  disappearance 
of  the  specific  investment.  On  the  other  hand  the  Reserve 
is  no  more  secure  because  of  the  specific  investment,  for 
supposing  that  the  business  of  the  year  following  the  show- 
ing of  Form  86  results  in  a  net  loss  of  $5,000,  the  Balance 
Sheet  then  becomes: 

FORM  88. 
Dr.  Balance  Sheet.  Cr. 


Miscellaneous  Assets* $115,000 

Investment 5,000 


$120,000 


Capital $100,000 

Debts 20,000 

Reserve  for  Extension. . . 

$120,000 


SUKPLUS    AND    RESERVES 


247 


so  that  while  the  specific  investment  is  still  intact  the  Re- 
serve has  disappeared  as  effectively  as  possible.  It  would 
be  illegitimate  to  show 

FORM  89. 
Dr.  Balance  Sheet.  Cr. 


Miscellaneous  Assets $115,000 

Investment  of  Reserve 

Fund 5,000 

Loss 5,000 

$125,000 


Capital $100,000 

Debts 20,000 

Reserve  for  Extensions . .         5,000 


$125,000 


for  the  Reserve  indicates  that  there  has  been  a  reserva- 
tion of  part  of  the  profits  amounting  to  $5,000  while  the 
Loss  item  shows  there  are  no  profits  to  be  reserved.  This 
is  shown  even  by  Pixley  who,  himself,  argues  strongly  that 
a  Reserve  Fund  must  be  specifically  invested. 

3.  And  finally,  although  this  pertains  to  corporation 
finance  rather  than  to  accounting,  the  identification  of  Re- 
serve with  specific  assets  lends  itself  easily  to  two  false 
theories : 

(1)  That  an  outside  investment  is  a  better  holding  for 
the  corporation  than  an  investment  in  extending  its  own 
plant,  and  (2)  that  where  a  fund  of  cash,  or  other  liquid 
assets  is  desirable  as  a  provision  for  emergencies,  such 
provision  need  not  be  made  out  of  capital,  but  only  as 
profits  accumulate.  The  first  of  these  views  is  undoubtedly 
true  in  certain  circumstances,  as  where  provision  is  being 
made  for  an  emergency  demanding  ready  funds,  but  as  a 
general  principle  it  is  without  validity.  The  second  view 
is  altogether  unsound  and  vicious  in  principle  and  in 
practice. 

In  such  matters,  where  personal  opinion  and  taste  have 
much  weight,  it  may  be  well  to  quote  two  leading  authori- 
ties, one  German  and  the  other  English.  Says  Rehm: 


248  MODERN   ACCOUNTING 

"  A  Reserve  Fund  is  not  an  asset  but  merely  a  technical 
indication  of  property  in  such.  It  signifies  that  a  given 
value  of  assets  may  not  be  distributed  or  disbursed;  but 
as  it  is  not  assets  it  cannot  be  an  item  on  the  Asset  side 
of  the  Balance  Sheet,  and  accordingly  it  also  cannot  be 
transferred  into  assets  and  invested  in  given  securities. ' ' l 
Dicksee  similarly  says:  "  It  cannot  be  too  strongly  ad- 
vanced that  the  question  as  to  whether  or  not  any  given 
Reserve  Fund  is  represented  by  assets  consisting  of  mar- 
ketable securities  outside  the  business  or  by  less  readily 
marketable  assets  employed  in  the  business  as  fixed  (or 
working)  capital,  is  comparatively  speaking  of  little  im- 
portance. The  most  casual  perusal  of  any  Balance  Sheet 
will  show  at  a  glance,  even  to  the  least  informed,  by  which 
class  of  assets  the  Reserve  Fund  is  represented. ' ' 2  On 
the  other  hand,  Pixley,  Dawson,  and  Whatley  object  to 
the  use  of  the  term  Reserve  Fund  where  there  is  not  a  cor- 
responding specific  asset.  In  the  case  of  Hoare  and  Com- 
pany, before  the  Court  of  Appeals,  Vaughan  Williams, 
L.  J.,  implies  there  is  no  Reserve  Fund  unless  the  assets 
are  specifically  set  aside,  but  Romer  and  Cozens-Hardy, 
L.  JJ.,  speak  of  a  Reserve  Fund  where  there  is  no  sepa- 
rate investment.  Somewhat  more  specific  is  the  provision 
in  the  revised  form  of  Table  A  of  the  English  Compa- 
nies Act.  This  is  a  model  form  of  articles  of  association 
which  applies  to  all  companies  unless  they  specifically 
adopt  other  articles.  In  this  it  is  provided  (Sec.  99)  that 
reserves  for  any  purpose  may  at  the  discretion  of  the  di- 
rectors "  either  be  employed  in  the  business  of  the  com- 
pany or  be  invested  in  such  investments  (other  than  shares 
of  the  company)  as  the  directors  may  from  time  to  time 
think  fit." 

In  accounting  practice  much  diversity  is  found.     The 

J  Die  Bilanzen,  571.    See  also  H.  V.  Simon:  Die  Bilanzen  derAktien- 
gesellschaften,  §  60.  *  Auditing,  p.  287. 


SURPLUS   AND   RESERVES  249 

great  majority  of  Reserves  shown  in  Balance  Sheets  do  not 
show  a  corresponding  special  investment.  Where  there 
is  such  an  investment  the  more  approved  form  is  to  indi- 
cate it  by  using  some  such  title  as  that  recommended  by 
A.  Lowes  Dickinson,  "  Fund  Assets,"  as  for  instance  the 
Illinois  Central  shows  "  Assets  in  Improvement  Fund," 
"  Assets  in  Surplus  Dividend  Fund,"  and  "  Assets  in 
Pension  Fund,"  each  of  which  is  equal  in  amount  to  a 
corresponding  Fund  on  the  credit  side  of  the  Balance 
Sheet.  In  other  cases  the  investments  shown  are  not 
equivalent  to  the  Reserve,  only  a  portion  of  the  Reserve 
being  specifically  invested  as  is  seen  by  reference  to  the 
Balance  Sheet  of  the  United  States  Steel  Corporation.  In 
France  the  specific  investment  of  reserves  in  outside  securi- 
ties is  not  customary. 

An  attempt  is  made  at  times  to  differentiate  between 
what  is  called  a  Reserve  and  a  Reserve  Fund.  Unfortu- 
nately there  is  no  uniformity  in  the  distinctions  made,  as 
is  shown  by  the  various  definitions  of  Reserve  Fund  given 
by  different  authors. 

1.  "  Reserve  Fund  is  an  asset  item  signifying  that  cer- 
tain forms  of  wealth  have  been  specifically  set  aside  for 
a  given  purpose.    This  may  or  may  not  be  the  equivalent 
of  a  Reserve  Account  appearing  in  the  credit  side  of  the 
Balance  Sheet."      (Keister.     Corporation  Accounting,  p. 
71.) 

2.  "  Reserve   Fund  is  a  credit  item  indicating  that 
profits  have  been  reserved   and  that   a  special  fund  of 
wealth  will  be  found  on  the  debit  side  of  the  Balance 
Sheet  representing  the  reserve,  one  for  which  there  has 
been  a  special  investment  made,  a  specially  covered  re- 
serve."    (Pixley.    Duties  of  Auditors,  I,  p.  359.) 

3.  "  Reserve  Fund  is  a  credit  item  representing  that 
the  reservation  is  made  out  of  net  profits,  in  contradistinc- 


250  MODERN   ACCOUNTING 

tion  to  Reserve  Account,  which  indicates  a  charge  to  Profit 
and  Loss  before  net  profits  are  obtained.  Reserve  Fund 
indicates  actual  profits,  Reserve  Account  may  be  merely 
a  depreciation  account."  (Dicksee.  Depreciation,  Re- 
serve and  Reserve  Funds,  p.  51.) 

4.  "  Reserve  Fund  is  a  Reserve  for  general  purposes, 
\vith  perhaps  no  distinct  object  in  view  but  available  for 
all  contingent  purposes,  in  contradistinction  to  a  reserve 
account  provided  for  a  definite  and  well-known  contin- 
gency."    (Eddis.    In  Thome's  Twentieth  Century  Book- 
keeping, §  424.) 

5.  "  Reserve  Fund  is  a  Reserve  which  is  shown  on  the 
Balance    Sheet   in   contradistinction   to   Secret  Reserve." 
(Rehm.    Die  Bilanzen,  p.  543.) 

In  nomenclature  employed  in  the  present  treatise  the 
equivalents  for  several  uses  of  the  ' '  Reserve  Fund  ' '  given 
above  are  as  follows: 

1.  Investment  of  Reserve  (or  similar  title). 

2.  Specially  Covered  Reserve. 

3.  Reserved  Profits,  or  simply  Reserve. 

4.  General  Reserve,  or  Surplus. 

5.  Open  Reserve. 

Much  of  the  confusion  is  caused  by  the  fact  that  the 
term  Reserve  is  used  in  connection  with  banking  and  in- 
surance in  an  entirely  different  sense  from  that  in  gen- 
eral bookkeeping  practice.  Thus  the  National  Bank  Act, 
general  banking  literature,  and  at  times  even  the  Balance 
Sheets  of  the  banks  use  "  Reserve  "  as  indicating  the  en- 
tire cash  on  hand  or  deposits  in  certain  banks  deemed  by 
law  or  custom  equivalent  to  cash.  A  condensed  Balance 
Sheet,  such  as  is  published  for  advertising  purposes,  may 
read 


SURPLUS    AND    RESERVES 


251 


Resources. 


FORM  90. 
Condensed  Balance  Sheet. 

Liabilities. 


Loans  and  discounts..  .$11,100,000 

Bonds 1,500,000 

Reserve 7,000,000 


$19,600,000 


Capital $2,000,000 

Surplus  and  Undivided 

Profits 1,100,000 

Deposits 16,500,000 

$19,600,000 


Reserve  in  this  sense  evidently  has  nothing  to  do  with 
profits,  and  its  maintenance  is  in  no  wise  dependent  upon 
the  existence  of  accumulated  profits;  but  in  law  and  in 
banking  practice  it  is  proportionate  to  the  deposits,  not 
to  profits.  Similarly  Reserve  in  insurance  has  a  specific 
meaning  referring  to  certain  classes  of  assets  which  must 
be  kept  on  hand  to  cover  the  actuarial  value  of  outstand- 
ing risks.  Again  this  is  proportionate  to  a  given  item  of 
liabilities,  not  to  profits.  In  both  of  these  cases  the  items 
are  better  listed,  not  under  "  Reserve  "  but  under  some 
title  appropriate  to  the  asset  itself.  The  "  Reserve  "  of 
the  bank  is  really  "  Cash  "  and  "  Deposits  with  approved 
reserve  agents  "  and  is  thus  correctly  stated  in  the  detailed 
Balance  Sheet.  The  "  Reserve  "  of  the  Insurance*  Com- 
pany is  really  "  Cash,"  "  Bonds,"  and  similar  items, 
while  "  Reserve,"  as  it  appears  among  the  liabilities,  is 
merely  an  indication  that  part  of  the  accumulated  profits 
is  not  to  be  distributed  as  dividends.  It  is  not  the  assets 
themselves  but  represents  at  most  a  state  of  mind  regard- 
ing certain  assets.  The  exceptional  use  of  "  Reserve  "  in 
banking  and  insurance  literature  may  sometimes  be  con- 
fusing but  the  matter  is  so  simple  that  it  should  cause  no 
serious  misunderstanding. 

A  Reserve  exists  when  an  increment  of  assets  is  with- 
held from  distribution  to  the  stockholders  or  proprietors; 
that  is,  whenever  the  excess  of  the  total  value  of  the  net 


252 


MODERN   ACCOUNTING 


assets  over  the  original  capital  is  retained  by  the  company. 
It  is  an  ecomonic  fact  and  is  independent  of  whether  the 
accounts  show  the  existence  of  such  a  surplus  or  not.  In 
corporations  desiring  to  be  considered  conservative,  or 
wishing  to  escape  taxation,  or  to  conceal  large  profits,  it 
is  not  uncommon  purposely  to  conceal  the  existence  of 
such  a  Reserve.  This  is  done  whenever  there  is  an  under- 
valuation of  assets,  or  less  frequently  when  there  is  an 
overstatement  of  liabilities.  In  such  cases  there  is  said 
to  be  a  Secret  Reserve.  Thus  in. a  company  whose  Balance 
Sheet  shows: 

FORM  91. 
Dr.  Balance  Sheet.  Cr. 


Plant,  etc $90,000 

Less  Deprecia- 
tion      5,000 

-    $85,000 
Cash 10,000 

$95,000 


Capital. 
Profits. 


$90,000 
5,000 


$95,000 


if  an  additional  depreciation  of  $5,000  is  reckoned,  one 
not  represented  by  an  actual  loss  or  decline  in  value,  the 


Balance  Sheet  will  read: 


Dr. 


FORM  92. 
Balance  Sheet. 


Cr. 


Plant,  etc $90,000 

Less  Deprecia- 
tion   10,000 


$80,000 


Cash 10,000 

$90,000 


Capital $90,000 


$90,000 


Despite  the  statement  here  made  the  net  value  of  the 
assets   is   really   $95,000,    which   exceeds   the    capital   by 


SURPLUS   AND   RESERVES  253 

$5,000.  As  no  profits  appear  in  the  Balance  Sheet,  no  divi- 
dends can  be  declared,  and  the  $5,000  cash,  which  might 
otherwise  have  been  distributed,  is  perforce  reserved  as 
an  addition  to  the  working  capital  of  the  concern.  Such 
a  condition  may  also  be  produced  by  treating  as  expenses, 
or  by  charging  direct  to  Profit  and  Loss  account,  pay- 
ments which  really  represent  the  purchase  of  new  assets. 
If  $5,000  is  spent  in  making  some  unquestioned  improve- 
ment or  addition  to  the  plant,  the  normal  entry  is  to 
charge  the  amount  to  "  Plant  "  or  to  some  synonymous 
account.  A  change  in  the  form  of  assets  held  from  Cash 
to  Plant  does  not  affect  Profits,  or  Surplus.  But  if  the 
payment  is  treated  as  though  it  were  a  mere  expense,  the 
total  assets  are  apparently  diminished  when  the  Cash  is 
paid,  and  no  showing  is  made  of  the  new  asset  gained  by 
purchase.  Whether  the  charge  is  made  originally  to  Ex- 
pense and  thus  indirectly  diminishes  profit,  or  whether  the 
charge  is  made  direct  against  Profit  and  Loss,  or  against 
some  special  or  general  Reserve,  the  effect  is*  the  same.  In 
one  way  or  another  the  assets  held  are  understated  and  to 
an  equivalent  amount  the  showing  of  accumulated  profits 
is  less  than  the  correct  amount. 

Banks  are  especially  given  to  this  practice  doubtless 
with  the  purpose  of  being  able  to  cover  losses  without  dis- 
closing them  to  the  public.  Thus  the  First  National  Bank 
of  New  York  City  is  said  to  have  covered  a  defalcation  of 
$690,000  because  it  had  so  large  a  Secret  Eeserve.  This 
could  be  done  by  bringing  into  the  Balance  Sheet  enough 
of  the  assets  representing  the  Secret  Reserve  to  cover  the 
unusual  loss. 

Railroads,  too,  especially  those  desiring  a  reputation 
for  conservatism  have  acted  similarly  either  by  violently 
marking  down  the  value  of  the  road,  as  was  done  by  the 
Chicago  and  Northwestern  Railway  in  1893;  or  by  charg- 
ing to  operation  and  maintenance  sums  representing  very 


254  MODERN   ACCOUNTING 

material  additions  to  the  physical  property,  as  was  done 
by  the  same  road  to  the  extent  of  nearly  $5,000,000  a 
year  for  the  seven  successive  years  from  1900  to  1906. 
An  even  more  striking  charge,  one  of  $13,000,000,  part 
of  the  expense  of  constructing  its  tunnel,  was  made  by  the 
Pennsylvania  against  a  special  Surplus  in  1906. 

Again  appears  a  case  of  justifying  a  practice  abhorrent 
to  accounting  principles,  yet  not  without  certain  practical 
merits.  In  the  anxiety  to  escape  the  prevalent  temptation 
to  exaggerate  the  value  of  the  assets,  which  in  many  cases 
has  led  to  such  disgraceful  results,  conservative  financiers 
applaud  an  equally  erroneous,  but  perhaps  less  dangerous 
tendency  to  understatement.  But  the  creation  of  a  Secret 
Reserve  is  not  without  its  dangers.  It  may  be  used  as  a 
means  of  refusing  to  pay  dividends  really  earned,  which 
so  far  as  it  applies  to  holders  of  income  bonds  or  non- 
cumulative  preferred  stock,  may  work  an  irreparable  loss. 
Even  where  there  are  no  such  divisions  of  interests  it  may 
lead  ignorant  stockholders,  thinking  the  Balance  Sheet  cor- 
rect, to  dispose  of  their  stock  at  less  than  its  real  value. 

The  position  which  the  Interstate  Commerce  Commis- 
sion has  taken  against  the  practice  of  charging  to  operat- 
ing expenses  payments  really  of  the  nature  of  betterments 
is  decidedly  healthful.  This  has  already  been  attacked  by 
the  technical  press,  and  has  been  spoken  of  as  "  casting 
to  the  winds  the  whole  system  of  conservative  finance 
which  has  been  the  boast  of  many  American  railroad  com- 
panies. ' ' l  This  is  curious  as  coming  from  the  organ  of 
the  Chartered  Accountants,  whose  council  had  previously 
taken  ground  that  the  existence  of  Secret  Reserves  makes 
the  Balance  Sheet  criminally  false.  To  identify  conserva- 
tive finance  with  incorrect  statements  is  a  dangerous  prece- 
dent, for  the  use  of  untruth  in  a  good  cause  is  likely  to 
induce  an  attitude  of  mind  in  which  untruthfulness  be- 

»  Accountant,  July  20,  1907. 


SURPLUS  AXD  RESERVES        255 

comes  chronic  and  ineradicable.  It  is  hard  to  believe  that 
so  good  a  cause  as  financial  conservatism  needs  such  unholy 
allies  as  misrepresentation  and  deception. 

An  extreme  type  of  a  Secret  Reserve,  one  which  the 
directors  were  authorized  to  expend  without  accounting  to 
the  stockholders  therefor,  was  brought  to  notice  in  connec- 
tion with  the  Birmingham  Small  Arms  Company.  The 
articles  of  the  company  authorized  the  directors  to  set 
aside,  out  of  the  profits,  an  "  Internal  Reserve  Fund  " 
which  need  not  be  disclosed  by  the  Balance  Sheet,  the 
directors  to  use  the  Reserve  Fund  in  any  way  which  they 
think  will  promote  the  interests  of  the  company  without 
giving  any  information  to  the  shareholders  regarding  the 
amount  or  application  of  this  Reserve.  In  discussing  this 
provision  Justice  Buckley  said:  "  The  special  resolutions 
in  the  present  case  provide  that  the  Balance  Sheet  shall 
not  disclose  the  internal  Reserve  Fund ;  it  must,  therefore, 
omit  on  the  assets'  side  of  the  Balance  Sheet  the  assets 
whi-jih  make  up  the  amount  standing  to  the  credit  of  that 
fund  and  the  contra  item— namely,  the  credit  balance  of 
the  fund — on  the  liability  side.  The  result  will  be  to  show 
the  financial  position  of  the  company  to  be  not  as  good  as 
in  fact  it  is.  If  the  Balance  Sheet  be  so  worded  as  to  show 
that  there  is  an  undisclosed  asset,  the  existence  of  which 
makes  the  financial  position  better  than  shown  such  a  Bal- 
ance Sheet  will  not,  in  my  judgment,  be  necessarily  incon- 
sistent with  the  Act  of  Parliament.  Assets  are  often  by 
reason  of  prudence  estimated,  and  stated  to  be  estimated, 
at  less  than  their  real  value.  The  purpose  of  the  Balance 
Sheet  is  primarily  to  show  that  the  financial  position  of 
the  company  is  at  least  as  good  as  there  stated,  not  to  show 
that  it  is  not,  or  may  not  be  better."  ( [1906]  2  Ch.  378.) 

A  Surplus  being  nothing  but  accumulated  profits,  its 
disbursement  is  secured  in  any  way  in  which  profits  are 
disbursed  save  where  some  particular  statute  or  by-law 


256  MODERN   ACCOUNTING 

prevents.  More  strictly  speaking  there  occurs  a  cancella- 
tion rather  than  a  disbursement  of  Surplus,  for  a  Surplus 
in  the  sense  of  an  account  on  the  Credit  side  of  the  Balance 
Sheet  cannot  itself  be  disbursed.  Certain  tangible  assets 
may  be  paid  out  and  this  may  work  a  cancellation  of  the 
Credit.  The  bookkeeping  entries  in  connection  with  such 
cancellation  remain  for  consideration. 

A  Reserve  created  to  provide  against  some  unusual  loss 
logically  remains  intact  until  such  loss  occurs.  This  may 
be  a  loss  by  fire  or  other  accident,  a  loss  due  to  default  by 
trade  debtors  or  on  securities  held,  a  loss  due  to  unfavor- 
able results  in  business  operations.  Such  a  loss  would 
otherwise  be  charged  to  Profit  and  Loss,  or  to  Capital,  but 
where  a  Reserve  is  held  the  unusual  loss  may  appropri- 
ately be  charged  against  such  Reserve,  leaving  the  current 
profits  from  ordinary  business  still  available  for  dividends. 
Similarly,  where  the  Reserve  is  used  to  pay  a  dividend, 
otherwise  unearned,  there  results  a  cancellation  of  some 
part  of  the  Reserve,  just  as  a  dividend  paid  in  ordinary 
circumstances  works  a  cancellation  of  the  credit  balance  to 
Net  Profits.  "Whether  the  charge  for  dividend  is  made 
direct  to  the  Reserve  account,  or  whether  part  of  the  Re- 
serve is  transferred  back  to  the  Profit  and  Loss  account 
from  which  it  originated  is  immaterial  so  far  as  the  final 
showing  is  concerned.  The  Reserve  being  a  reservation  of 
profits,  may  either  be  used  to  cancel  any  loss,  as  current 
profits  would  be  used ;  or  at  any  time  may  be  canceled  by 
retransference  to  Profit  and  Loss,  which  simply  signifies 
that  profits  for  a  while  reserved  are  no  longer  so,  but  are 
to  be  treated  in  the  usual  way. 

But  it  has  been  shown  that  sometimes— and  frequently 
—a  Reserve  is  created  not  to  cover  a  loss  or  make  possible 
a  dividend  but  to  provide  additional  plant,  to  cover  an 
Exchange,  not  a  Profit  and  Loss  transaction. 

Thus  in  the  following  case: 


Dr. 


SURPLUS    AND    RESERVES 

FORM  93. 

Balance  Sheet. 


25? 

CV. 


Plant $90,000 

Cash 20,000 

$110,000 


Capital $100,000 

Reserve  for  Extensions . .      1 0,000 

$110,000 


the  Reserve  may  have  been  created  for  the  specific  purpose 
of  purchasing  an  additional  machine.  The  time  has  come 
when  it  is  needed,  and  the  Reserve  is  just  sufficient  to 
cover  the  cost.  Cash  is  lessened  by  $10,000  when  the  ma- 
chine is  purchased  but  this  expenditure  is  no  loss,  as  a 
machine  of  equal  value  is  received  in  exchange.  Conse- 
quently the  Balance  Sheet  should  show: 


Dr. 


FORM  94.  - 
Balance  Sheet. 


Cr. 


Plant $90,000 

Additions.......    10,000 


Cash. 


$100,000 
10,000 

$110,000 


Capital $100,000 

Reserve  for  Extensions . .      10,000 


$110,000 


In  many  cases,  however,  Cash  is  credited  and  Reserve  is 
debited  showing  merely: 

FORM  95. 
Dr.  Balance  Sheet.  Cr. 


Plant $90,000 

Cash 10,000 

$100,000 


Capital $100,000 


$100,000 


But  this  is  a  case  of  creating  a  Secret  Reserve,  which  has 
already  been  criticised.  There  is  no  justification  in  charg- 
ing to  Reserve  anything  which  could  not  legitimately  be 


258 


MODEKN   ACCOUNTING 


charged  against  profits.  The  purchase  of  a  machine,  an 
Exchange  transaction,  should  not  thus  be  charged.  It  may, 
however,  be  desirable  to  make  some  change  in  the  Reserve 
item.  It  seems  somewhat  absurd  to  have  a  Reserve  to  pro- 
vide for  something  already  secured.  Consequently  the 
credit  to  Reserve  for  Extension  may  be  canceled  and  a 
corresponding  credit  made  either  to  the  general  Profit  and 
Loss  account,  or  to  the  general  Surplus  account.  Or  if  it 
is  desired  to  be  more  specific  there  can  appear  the  cum- 
brous but  minutely  accurate  phrase:  "  Reserve  created  by 
purchasing  machinery  out  of  profits. ' '  Any  of  these  book- 
ings is  entirely  correct.  Crediting  the  Reserve  back  to 
Profit  and  Loss  is  legitimate  but  it  indicates  a  change  in 
policy,  for  if  credited  to  profits  dividends  of  that  amount 
can  then  be  paid  and  the  machine  is  no  longer  paid  for  out 
of  reserved  profits  but  from  capital.  Doubtless  a  simple 
transfer  to  Surplus,  or  general  Reserve  most  recommends 
itself. 

The  payment  of  debt,  like  the  purchase  of  assets,  is  not 
a  loss  transaction,  and  similarly  is  not  a  logical  charge 
against  a  Reserve.  The  treatment  of  a  Reserve  provided 
for  the  payment  of  debts,  should,  therefore,  be  identical 
with  that  of  a  Reserve  for  Extensions  described  above. 

It  is  to  be  noted  that  the  booking  is  identical  whether 
the  Reserve  is  specifically  covered  or  not.  Where  specific 
investments  are  held,  presumably  they  will  be  sold  to  pro- 
vide cash  with  which  to  cover  the  payment.  Thus  with  a 
Balance  Sheet  showing: 

FORM  96. 
Dr.  Balance  Sheet.  Cr, 


Plant,  etc $90,000 

Investments 10,000 

Cash 10,000 

$110,000 


Capital $100,000 

Reserve  for  Extensions. .      10,000 


$110,000 


SURPLUS   AND   RESERVES 


259 


the  company  may  make  the  addition  to  its  plant  contem- 
plated when  the  Reserve  for  Extension  was  established. 
Whether  the  payment  is  made  from  the  cash  on  hand  or 
from  $10,000  realized  from  the  sale  of  the  investments,  is 
immaterial  so  far  as  it  affects  the  rest  of  the  Balance  Sheet. 
In  either  case  the  item  "  Plant  "  is  increased  by  $10,000, 
and  the  treatment  of  the  Reserve  is  the  same.  The  amount 
of  the  latter  remains  unaltered  although  the  term  used  in 
the  Balance  Sheet  may  be  changed  as  suggested  in  the 
preceding  paragraph.  Even  when  specific  investments  are 
held  to  cover  the  Reserve  it  may  be  that  a  flurry  in  the 
investment  market  makes  it  undesirable  to  sell  them,  and 
the  purchase  is  made  with  cash  already  in  hand  or  even  by 
credit.  In  the  last  named  case  the  Balance  Sheet  becomes : 


Or. 


FORM  97. 
Balance  Sheet. 


Cr. 


Plant,  etc $100,000 

Investments 10,000 

Ovsh 10,000 

$120,000 


Capital $100,000 

Bills  payable 10,000 

Reserve 10,000 

$120,000 


This  again  emphasizes  the  fact  that  the  booking  of  Reserves 
is  practically  independent  of  the  existence  of  specific  assets. 
The  item  Reserve  for  Insurance  is  frequently  found  in 
Balance  Sheets.  It  generally  occurs  where  a  company, 
whose  plant  is  so  widely  scattered  that  there  is  little  likeli- 
hood of  large  loss  by  a  single  fire,  decides  not  to  carry  any 
insurance  but  to  stand  its  own  loss  should  one  occur.  In 
such  circumstances  it  is  assumed  that  the  insurance  pre- 
miums saved  will  more  than  cover  losses  as  they  occur.  To 
carry  out  this  policy  an  annual  charge,  perhaps  equivalent 
to  regular  insurance  premiums,  is  made  against  earnings, 
and  an  equivalent  amount  is  credited  to  Reserve  for  Insur- 
ance. There  may,  or  may  not  be  a  specific  investment 
18 


260  MODERN   ACCOUNTING 

made  to  cover  the  reserve.  It  is  somewhat  difficult  to  deter- 
mine whether  such  a  reserve  is  really  a  part  of  profits. 
Were  the  company  to  go  into  liquidation,  or  to  change 
its  policy  and  provide  for  future  losses  by  carrying  regu- 
lar insurance  the  balance  then  standing  to  the  credit  of 
the  Insurance  Keserve  would  unquestionably  represent  an 
addition  to  profits  which  could  be  distributed  as  dividends. 
But  so  long  as  the  company  maintains  its  business  and 
refrains  from  insuring,  the  Reserve  is  closely  allied  to  a 
Depreciation  account  or  a  provision  for  bad  debts.  If  the 
plant  is  sufficiently  large  and  scattered  the  law  of  proba- 
bilities makes  certain  that  a  loss  will  some  time  occur.  If 
an  accurate  estimate  shows  that  there  will  be  an  average 
loss  of  $20,000  each  ten  years,  it  is  clear  that  the  account- 
ant should  charge  $2,000  (ignoring  the  compounding  of 
interest)  as  the  share  of  such  loss  properly  to  be  allocated 
to  each  year's  business.  And  the  accumulation  of  such 
charges  is  not  so  much  a  part  of  net  profits  as  a  represen- 
tation of  a  loss  logically  anticipated  but  as  yet  unrealized. 

BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  XIII 

DAWSON,  S.  S.  Reserves  and  Reserve  Funds.  Article  in  Encyclo- 
paedia of  Accounting,  V,  p.  482. 

DICKSEE,  L.  R.  Depreciation,  Reserves,  and  Reserve  Funds. 
London,  1903. 

MEADE,  E.  S.  The  Management  of  the  Surplus  Reserve.  Publica- 
tions of  the  American  Economic  A  ssociation.  3rd  series.  V.  p .  245. 

NEUKAMP,  E.  Der  Reservefonds  der  Aktiengesellschaften.  Gold- 
Schmidt's  Zeitschrift  f.  d.  gesamte  Handelsrecht.  XXXVIII,  10. 

Das  Dogma  von  der  "  Bilanzwahrheit "  Ibid.,  XLVIII,  450. 

[A  strong  argument  in  favor  of  secret  reserves.] 

PIXLEY,  F.  W.  Auditors,  their  Duties  and  Responsibilities.  I.  358- 
361.  Ninth  edition.  London,  1906. 

REHM,  H.  Loc.  cit.,  542-642.  [Emphasizes  the  distinction  between 
a  real  «nd  a  fictitious  reserve.] 

SIMON,  H.  V.    Loc.  cit..  227-283. 


CHAPTER    XIV 


SINKING   FUNDS 

A  SINKING  FUND  in  the  strict  sense  is  a  fund  raised  by 
annual  contributions  for  the  purppse  of  providing  means 
for  paying  off  a  funded  debt.  The  term  is  of  very  fre- 
quent occurrence  in  accounting,  especially  in  the  Balance 
Sheets  of  American  railways.  Its  use  is  however  not  uni- 
form, and  an  examination  of  a  number  of  railroad  reports 
will  disclose  some  in  which  it  appears  only  on  the  Liability 
side,  others  where  it  is  found  only  among  the  Assets,  and 
still  others  in  which  Sinking  Fund  appears  both  as  a  Debit 
and  a  Credit.  The  various  methods  in  which  this  is  done 
and  the  forms  in  which  the  transactions  are  booked  are  as 
follows : 

1.  A  given  sum  of  money  is  annually  paid  to  Sinking 
Fund  trustees  or  otherwise  set  aside  to  accumulate  at  com- 
pound interest  until  the  time  when  the  bonds  mature.  The 
payment  is  not  regarded  as  a  loss  or  an  expense,  which 
indeed  it  is  not,  for  the  payment  of  debt  not  being  an 
expense  certainly  the  preliminary  setting  aside  of  a  fund 
with  which  to  pay  the  debt  is  no  more  so.  Assuming  a 
road  whose  Balance  Sheet  shows: 


Dr. 


FORM  98. 
Balance  Sheet. 


Cr. 


Cost  of  road,  etc $99,000,000 

Cash 2,000,000 


$101,000,000 


Capital  Stock $50,000,000 

Funded  Debt 50,000,000 

Balance    of    Income 

Account 1 ,000,000 

$101,000,000 


261 


262 


MODERN   ACCOUNTING 


the  payment  to  the  Sinking  Fund  trustees  of  an  install- 
ment of  $500,000  produces  the  following  condition: 


Dr. 


FORM  99. 
Balance  Sheet. 


Cr. 


Cost  of  road,  etc $99,000,000 

Cash  in  hands  of  Sink- 
ing Fund  Trustees .          500,000 
Cash 1,500,000 

$101,000,000 


Capital  Stock $50,000,000 

Funded  Debt 50,000,000 

Balance    of    Income 

Account 1,000,000 

$101,000,000 


In  this  case  cash  has  been  taken  out  of  the  general  funds 
and  put  aside  to  provide  means  for  the  future  payment 
of  the  bonds.  There  is  no  indication  as  to  its  relation  to 
profits.  The  legal  requirement  by  contract  with  the  bond- 
holders is  that  funds  be  thus  set  aside  and  separately  held. 
So  long  as  this  is  done  it  is  immaterial  to  the  bondholders 
whether  the  cash  is  obtained  from  the  stockholders,  from 
loans  obtained  elsewhere,  or  from  accumulated  profits. 
The  Sinking  Fund  here  is  a  fund  of  assets,  analogous  to 
a  "  bank  reserve  "  and  not  a  Reserve  in  the  sense  of  re- 
served profits.  This  form  is  used,  for  instance,  by  the 
Chicago,  Rock  Island  and  Pacific. 

2.  Other  roads  are  accustomed  to  charge  the  amount  of 
the  Sinking  Fund  installment  to  the  Income  or  Profit  and 
Loss  account.  In  this  case  a  distinct  reserve  is  created  by 
withholding  part  of  the  accumulated  profits.  Where  this 
is  done  the  Balance  Sheet  becomes: 


Dr. 


FORM  100. 
Balance  Sheet. 


Cr. 


Cost  of  road,  etc $99,000,000 

Cash  in  hand  of  Sink- 

,      ing  Fund  Trustees.  500,000 

Cash 1,500,000 


$101,000,000 


Capital  Stock $50,000,000 

Funded  Debt 50,000,000 

Sinking  Fund 500,000 

Balance    of    Income 

Account 500,000 

$101,000,000 


SINKING  FUNDS  263 

which  is  the  form  used  by  the  Chicago  and  Northwestern 
Eailway,  and  many  other  corporations.  The  name  given 
to  the  account  varies  somewhat  in  the  different  reports,  but 
the  essential  thing  is  to  note  that  a  Reserve  Fund,  specially 
covered  by  cash  in  the  hands  of  the  trustees,  has  been 
established,  and  that  both  sides  of  the  Balance  Sheet  show 
the  amount  of  the  Sinking  Fund. 

3.  The  other  forms  are  variations  of  the  two  just  given, 
and  depend  on  the  method  of  employing  the  funds  paid 
to  the  trustees,  and  of  booking  the  transactions.  The  pur- 
pose of  the  Sinking  Fund  being  to  provide  means  which 
shall  serve  to  wipe  out  a  given  issue  of  bonds  at  a  certain 
time,  this  end  can  be  gained  either  by  leaving  the  cash 
on  deposit  in  a  trust  company,  by  investing  it  in  outside 
securities,  or  by  buying  up  some  of  the  Company's  own 
bonds.  The  first  plan  is  objectionable  because  of  the  small 
rate  of  interest  received,  the  second  involves  the  possibility 
of  risk,  the  danger  of  misappropriation  of  the  large  sums 
of  securities  held  by  trustees,  and  a  relative  low  rate  of 
interest,  for  the  trustees  will  prefer  bonds  whose  greater 
security  means  lower  returns.  Investment  in  the  Com- 
pany's own  securities  is  therefore  the  most  desirable  as 
well  as  the  customary  method,  and  so  far  as  practicable 
the  bonds  purchased  are  part  of  the  very  issue  to  be  cov- 
ered by^  the  Sinking  Fund.  Here  the  question  of  security 
cannot  arise,  for  the  purchase  of  the  bonds  in  itself  secures 
the  desired  end;  misappropriation  can  be  prevented  by 
canceling  or  by  rendering  the  bonds  otherwise  non-nego- 
tiable ;  and  the  interest  will  be  higher  than  could  be  gained 
by  any  investment  of  approximately  equal  security. 

Where  outside  investments  are  made  the  securities  held 
must  appear  in  the  Balance  Sheet  as  p&rt  of  the  assets  of 
the  company,  under  the  heading  ' '  Cash  and  securities  held 
by  Sinking  Fund  Trustees  "  or  an  equivalent  phrase;  but 
where  bonds  of  the  company  are  purchased  different  meth- 


264 


MODEKN   ACCOUNTING 


ods  of  booking  the  transaction  are  employed.  Sometimes 
they  too  are  included  among  the  assets  embraced  in  the 
heading  just  given,  but  in  other  companies  bonds  so  held 
are  not  counted  as  assets,  and  are  therefore  necessarily 
canceled  from  the  bonds  listed  among  the  liabilities.  This 
is  treating  the  bonds  purchased  for  the  Sinking  Fund  as  a 
payment  of  a  debt,  and  a  debt  paid  as  a  rule  no  longer 
appears  in  the  accounts.  Assuming  that  the  sinking  fund 
has  been  invested  in  the  company's  bonds,  and  that  these 
bonds  are  canceled,  the  Balance  Sheets  given  above  in 
forms  99  and  100  become  respectively 

FORM  101. 
Dr.  Balance  Sheet.  Cr. 


Cost  of  road,  etc . . 
Cash..   


$99,000,000 
1,500,000 


$100,500,000 


Capital  Stock $50,000,000 

Funded  Debt 49,500,000 

Balance    of    income 
account 1,000,000 

$100,500,000 


Dr. 


FORM  102. 

Balance  Sheet. 


Cr. 


Cost  of  road,  etc . . 
Cash 


$99,000,000 
1,500,000 


$100,500,000 


Capital  Stock $50,000,000 

Funded  Debt 49,500,000 

Sinking  Fund 500,000 

Balance    of    income 

account 500,000 

$100,500,000 


Illustrations  of  the  above  are  found  in  the  reports  of 
the  Louisville  and  Nashville  Railway,  which  uses  the  form 
101  so  far  as  it  concerns  the  bulk  of  its  sinking  fund  pay- 
ments, the  uninvested  balance  appearing  as  a  debit  with 
no  corresponding  credit;  and  in  the  balance  sheet  of  the 
United  States  Steel  Corporation,  given  in  Form  29,  which 
shows  a  credit  but  no  debit  for  the  bulk  of  its  sinking  fund 
operations. 


SINKING   FUNDS  265 

A  comparison  of  the  four  methods  shows  that  an  item 
representing  the  sinking  fund  appears  in  the  first  form 
only  among  the  debits,  in  the  second  in  both  debits  and 
credits,  in  the  third  in  neither  debit  nor  credit,  and  in  the 
fourth  in  the  credit  side  alone.  The  creditors  are  given 
the  security,  in  the  first  case,  of  certain  segregated  assets, 
but  no  assurance  that  the  total  assets  of  the  company  will 
be  increased.  In  the  second  case  the  reserved  assets  at  the 
same  time  constitute  an  increase  in  the  total  assets  of  the 
company,  gained  by  a  reservation  of  profits,  or  at  least 
there  is  the  guaranty  that  the  stockholders  take  no  divi- 
dends unless  profits  are  first  withheld  sufficient  to  provide 
for  repayment  of  the  debt.  In  the  third  method  no  specific 
assets  are  withheld  and  the  gross  assets  may  even  decline, 
but  the  outstanding  claims  are  reduced  so  that  the  margin 
of  security  is  increased.  In  the  fourth  there  is  a  similar 
reduction  in  liabilities,  but  in  this  instance  accompanied 
by  a  guaranty,  not  found  in  the  third  method,  that  the 
gross  assets  will  at  least  be  constant  while  the  net  assets 
are  being  increased  by  paying  debts  with  profits. 

The  theory  of  the  Sinking  Fund  involves  the  com- 
pounding of  interest  on  the  invested  installments.  Where 
outside  investments  are  made  this  is  simply  done  by  leav- 
ing in  the  hands  of  the  trustees  the  interest  received. 
Where  the  company's  own  bonds  are  purchased  it  involves 
the  payment  of  interest  on  the  entire  issue  of  bonds,  in- 
cluding those  held  by  the  sinking  fund,  and  regardless  of 
whether  these  bonds  are  canceled  and  subtracted  from  the 
liabilities  or  not.  This  interest  in  either  case  is  credited 
not  to  the  general  income  of  the  company  but  to  the  Sink- 
ing Fund,  from  the  investments  of  which  the  interest  is 
derived.  Thus  assuming  that  the  installment  of  $500,000 
in  the  illustrations  given  above  is  promptly  invested  at 
five  per  cent.,  the  Balance  Sheet  at  the  end  of  the  year — 
ignoring  other  changes — is : 


266 


MODERN"  ACCOUNTING 


Dr. 


FORM  103. 

Balance  Sheet. 


Cr. 


Cost  of  road,  etc ....  $99,000,000 
Cash  and  securities  in 

hands  of  Sinking 

Fund  Trustees 525,000 

Cash 1,500,000 

$101,025,000 


Capital $50,000,000 

Bonded  debt 50,000,000 

Sinking  Fund  and 

Accretions  thereto .  525,000 
Balance  of  income 

account 500,000 

$101,025,000 


As  the  years  pass  the  credit  to  ' '  Sinking  Fund  and  accre- 
tions thereto  "  and  the  "  Cash  and  securities  in  hands  of 
Sinking  Fund  Trustees  "  increase  pari  passu  by  the  accu- 
mulation of  compound  interest  on  the  several  installments 
paid. 

Much  discussion  has  occurred  in  the  field  of  both  public 
and  private  finance  as  to  the  economic  effects  of  adopting 
a  sinking  fund  policy.  Whether  this  indirect  and  rather 
cumbersome  method  of  retiring  debt  is  advantageous  or 
not  has  been  argued  with  great  vigor,  but  with  this  dis- 
cussion the  present  treatise  is  not  concerned.  Some  purely 
accounting  aspects  of  the  subject  are,  however,  of  interest. 

Sinking  fund  installments  being  in  most  cases  compul- 
sory under  the  mortgage,  they  are  frequently  treated  as 
fixed  charges,  together  with  interest  payments.  An  illus- 
tration is  found  in  the  reports  of  the  Chicago  and  North- 
western Railway  Company,  which  shows: 

FORM  104. 


Gross  earnings 

Operating  expenses  and  taxes 

Net  earnings 

Other  charges: 

Interest  $7.0 

Sinking  Funds J2 

Add  other  income. . , 


$55. 7 

38.6 

$17.1 


7.2 


$9.9 
.5 

$10.4 


SINKING  FUNDS  267 

On  the  other  hand  the  Pennsylvania  R.  R.  Company, 
obtaining  its  earnings  in  the  customary  way,  subtracts 
interest,  but  not  Sinking  Fund  installments,  to  obtain  the 
Net  Income,  and  from  the  Net  Income  are  subtracted  Con- 
tributions to  Sinking  Funds,  Special  Reserve,  and  Divi- 
dends, all  three  being  treated  as  homologous  items,  each 
being  an  appropriation  of  Net  Income,  not  a  charge  against 
Earnings. 

From  a  theoretical  view  point  the  latter  method  is  cor- 
rect, the  former  erroneous.  Payment  of  debt  not  being  in 
any  sense  an  expense  or  loss,  it  may  be  left  entirely  out 
of  the  Income  Account  as  has  been  shown  to  be  a  recog- 
nized method  of  treatment;  but  it  is  also  legitimate  to 
provide  for  making  such  payments  out  of  profits,  just  as 
provision  for  extending  a  fixed  plant  may  legitimately  be 
made  by  creating  a  Reserve;  but  in  neither  case  is  the 
essential  nature  of  the  transaction  altered,  and  this  is  cor- 
rectly reported  in  the  accounts  by  showing  it  as  a  dispo- 
sition of  profits. 

On  the  other  hand  may  be  cited  the  authority  of  M.  M. 
Kirkman,  Vice-President  of  the  Chicago  and  Northwestern 
Railway,  who  says: 

"  Sinking  fund  is  unrepresented  capital.  It  is  not 
chargeable  against  income  account  any  more  than  any 
other  capital  expenditure.  The  reason  why  we  so  often 
find  it  included  in  the  income  account  is  because  of  the 
conservatism  of  proprietors.  It  is  another  way  they  have 
of  strengthening  their  properties.  It  is  similar  in  effect 
to  making  improvements  with  net  earnings.  The  fact  that 
it  is  done  by  sagacious  and  practical  business  men  is,  in 
itself,  sufficient  evidence  that  it  is  proper. ' ' x 

But  the  analogy  here  given  is  not  quite  correct.  In 
charging  improvements  to  net  earnings  the  item  disap- 
pears entirely  from  the  Balance  Sheet  and  constitutes  a 

1  Science  of  Railways,  III,  p.  104. 


268  MODERN   ACCOUNTING 

Secret  Reserve.  This  is  apparently  never  done  in  regard 
to  the  Sinking  Fund.  The  payment  does  not  disappear 
but  is  either  held  among  the  assets  or  what  is  equivalent 
is  deducted  from  outstanding  debt.  The  alternative,  so 
far  as  the  showing  in  the  Balance  Sheet  is  concerned,  is 
between  retaining  an  unappropriated  Balance  to  Income 
and  a  Special  Reserve,  not  between  creating  a  secret  and 
an  open  reserve.  Charging  to  income  reduces  the  unap- 
propriated balance  and  doubtless  lessens  the  clamor  for 
extra  dividends  which  might  appear  as  that  balance  is 
augmented,  but  which  would  be  less  insistent  where  the 
amount  appears  as  Sinking  Fund.  To  charge  to  gross 
rather  than  to  net  income  affects  only  the  showing  in  cur- 
rent income  accounts,  not  at  all  the  cumulative  sum  in  the 
Balance  Sheet,  but  even  the  showing  of  the  annual  profits 
at  a  sum  larger  than  can  advisedly  be  distributed  is  at 
times  embarrassing.  While  the  net  profits  of  the  Chicago 
and  Northwestern  Railway  were  unquestionably  larger 
than  the  amount  shown,  the  amount  of  "  Net  profits  avail- 
able for  dividends  "  were  not  larger.  The  compulsory 
nature  of  the  Sinking  Fund  has  some  bearing,  it  is  true, 
but  neither  national  banks  nor  foreign  corporations  con- 
sider the  compulsory  establishment  of  a  surplus  a  reason 
for  understating  the  annual  net  profits,  and  they  do  not 
charge  the  required  percentage  of  their  profits  as  if  it 
were  an  expense,  but  show  it  properly  as  an  appropriation 
of  profits.  So  the  compulsory  nature  of  the  Sinking 
Fund,  while  lessening  the  amount  which  may  be  available 
for  dividends,  should  not  diminish  the  net  profits  shown. 
Even  the  decisions  of  the  courts,  that  profits  are  ascer- 
tained after  the  payment  of  Sinking  Funds  (Belfast  & 
Moosehead  Lake  Ry.  v.  Belfast,  71  Me.  445  (1885),  Ex- 
celsior Water  &  Mining  Co.  v.  Pierce,  90  Cal.  131  (1891)) 
like  the  similar  decisions  regarding  the  payment  of  the 
principal  of  the  debt,  are,  as  is  shown  in  Chapter  XII,  to 


SINKING  FUNDS 


269 


be  explained  as  a  ruling  against  forcing  dividends  rather 
than  as  a  scientific  definition  of  the  nature  of  profits. 

The  customary  treatment  of  interest  received  on  Sinking 
Fund  investments  is  similarly  inexact.  The  interest  thus 
received  is  part  of  the  income  of  the  company.  That  it  is 
immediately  appropriated  to  a  special  purpose,  does  not 
alter  its  nature  as  income  of  the  company.  As  such  it 
might  with  propriety,  indeed  it  logically  should,  appear 
in  the  Income  account.  But  in  practice,  where  the  Sinking 
Fund  appears  as  a  special  reserve,  the  income  derived  from 
its  investment  is  not  shown  in  the  Income  account  but  is 
credited  direct  to  the  fund  or  to  some  subordinate  account 
as  for  instance  "  Sinking  Fund  Accretions."  Thus  again 
the  showing  of  annual  profits  is  too  low,  although  the  Bal- 
ance Sheet  does  show  in  full  the  reserved  profits  held  in 
the  Sinking  Fund. 

In  the  normal  course,  when  the  time  comes  for  the  re- 
tirement of  the  bonds  covered  by  the  Sinking  Fund,  the 
credit  to  that  account  should  equal  the  amount  of  bonds. 
Where  the  specific  investment  of  the  funds  is  shown,  the 
Balance  Sheet  becomes: 


Dr. 


FORM  105. 
Balance  Sheet. 


Cr. 


Cost  of  road,  etc $99,000,000 

Cash,  etc.,  in  hands  of 
Sinking  Fund  Trus- 
tees    50,000,000 

Cash 1,500,000 

$150,500,000 


Capital  Stock  $50,000,000 

Funded  Debt 50,000,000 

Sinking  Fund 50,000,000 

Balance    of    Income 
Account  500,000 

$150,500,000 


At  this  point  the  bonds  are  presented  to  the  trustees  of 
the  Sinking  Fund  and  paid  by  them.  The  Balance  Sheet 
then  becomes: 


270 


MODERN   ACCOUNTING 


Dr. 


FORM  106. 

Balance  Sheet. 


Cr. 


Cost  of  road,  etc $99,000,000 

Cash 1,500,000 


$100,500,000 


Capital  Stock $50,000,000 

Sinking  Fund  (?) 50,000,000 

Balance    of    Income 
Account 500,000 

$100,500,000 


It  perhaps  seems  unreasonable  to  continue  the  Sinking 
Fund  under  that  title,  now  that  the  debt  has  been  re- 
deemed and  canceled.  The  entire  sum  could  with  pro- 
priety be  credited  back  to  Income  Account,  whence  it  all 
originally  came.  To  most  accountants,  however,  it  appears 
better  to  continue  it  as  a  special  reserve,  perhaps  under 
some  such  descriptive  title  as  that  proposed  by  Dicksee 
"  Accumulations  of  Revenue  which  have  provided  the 
wherewithal  to  Redeem  Loans/', or  so  far  as  accounting 
is  concerned,  it  can  legitimately  be  capitalized,  and  a  stock 
dividend  issued  for  it  to  the  stockholders.  Economically 
it  means  that  by  a  period  of  prolonged  abstinence  the 
stockholders,  formerly  having  only  a  half  interest  in  the 
economic  capital,  have  bought  out  the  bondholders'  inter- 
est of  $50,000,000,  making  payment  out  of  their  accumu- 
lated profits  or  savings. 

Where  the  Sinking  Fund  is  invested  in  the  bonds  of 
the  company  and  such  bonds  are  canceled 'and  disappear 
from  the  Balance  Sheet  (the  method  shown  is  Form  102 
above),  the  final  condition  will  be  the  same  as  that  in 
Form  106. 

Where  no  special  Sinking  Fund  is  shown  among  the 
liabilities  the  final  payment  of  the  debt  does  not  require 
any  further  alteration  of  the  Balance  Sheet,  for  the  pay- 
ment of  bonds,  either  gradually  or  in  mass  has  not  been 
charged  against  income,  and  there  is  no  need  for  reestab- 
lishing that  depleted  account. 


SINKING  FUNDS  271 

The  calculation  of  the  amount  required  for  a  Sinking 
Fund  is  as  follows.  The  problem  being  the  amount  pay- 
able at  the  end  of  each  year,  which  invested  at  a  given 
rate  of  interest  (i)  will  be  sufficient  to  pay  off  the  prin- 
cipal (P)  in  (n)  years.  In  this  calculation  the  interest 
annually  paid  on  the  bonds  is  neglected,  that  being  a  regu- 
lar charge  against  the  earnings  of  the  company,  the  Sink- 
ing Fund  installment  being  separately  handled. 

A  payment  of  $1  invested  at  the  end  of  the  first  year 
will  accumulate  at  compound  interest  until  the  end  of  the 
sinking  fund  period  of  n  years.  Its  accumulated  value 
will  therefore  be  (l-f-i)n—1,  the  second  installment  will 
accumulate  for  one  less  year  and  so  on,  for  a  series,  the 
next  to  the  last  installment  drawing  interest  for  only  one 
year,  the  last  installment  made  at  the  time  when  the  bonds 
'  mature,  not  having  any  time  for  investment.  The  series 
then  becomes 

(1  +  i)"-1  +  (1  +  i)"-2  .  .  .  (1  +  i)  +  1, 

which  may  be  simplified  to    (1  -f-  i)n —  1.     Dividing  the 

i 

total  amount  of  bonds  to  be  retired    (P)    by  this  sum, 
the   amount   of  the   annual  sinking   fund   installment   is 

obtained,  and 

i  P 
Sinking  Fund  Installment  = 

(l  +  i)n-l 

In  these  calculations  the  accountant  and  the  investor 
must  have  in  mind  that  there  is  bound  to  be  some  delay 
in  reinvestment  and  that  the  rate  to  be  obtained  is  almost 
certain  to  decline  through  any  protracted  period. 

It  is  however  by  no  means  necessary  that  the  Sinking 
Fund  should  equal  the  entire  principal  to  be  retired.  A 
provision  which  amounted  to  eighty,  sixty,  or  any  other 
considerable  proportion  of  the  funded  debt  would  in  the 


272  MODERK  ACCOUNTING 

case  of  a  perpetual  enterprise,  such  as  a  railroad,  offer 
security  sufficient  to  satisfy  the  creditor ;  for  if  to-day  the 
road  can  borrow  $100,000,000,  the  presumption  is  that 
twenty  years  hence  it  will  have  no  difficulty  in  borrowing 
half  that  sum,  if  it  should  prove  necessary  to  refund  the 
debt  not  covered  by  the  Sinking  Fund.  Where  the  enter- 
prise is  not  perpetual,  as  where  it  is  dependent  on  a  lim- 
ited franchise,  the  adequacy  of  the  Sinking  Fund  pro- 
vision is  more  important  and  the  failure  to  realize  the 
calculated  interest  may  be  a  decided  injury  to  the  bond- 
holder. 

The  relation  of  the  Sinking  Fund  to  Depreciation  has 
led  to  protracted  discussion,  especially  in  connection  with 
the  legal  restrictions  on  municipal  borrowing.  The  Eng- 
lish requirement  is  that  the  municipality,  desiring  to  bor- 
row for  public  service  utilities  must  provide  out  of  the 
revenue  both  for  a  Sinking  Fund  with  which  to  retire  the 
bonds  at  maturity,  and  also  for  a  Depreciation  Fund  with 
which  the  plant  can  be  replaced  when  worn  out.  But 
assuming  that  the  life  of  the  plant  and  the  duration  of 
the  bonds  are  the  same  this  leads  to  an  exact  doubling 
of  the  proper  charges  against  revenue.  "Whatever  good 
effect  this  may  have  in  preventing  reckless  undertaking  of 
municipal  enterprises,  it  clearly  does  not  lead  to  a  correct 
showing  of  the  profitableness  of  the  undertaking.  The 
relation  between  Sinking  Fund  and  Depreciation  is  better 
understood  by  accountants.  Thus  for  instance  the  certifi- 
cate of  the  Public  Accountants  attached  to  the  Balance 
Sheet  of  the  American  Hide  and  Leather  Company  con- 
tains the  following :  ' '  The  appropriation  out  of  profits  for 
the  purposes  of  the  Sinking  Fund  is  in  our  opinion,  suffi- 
cient to  take  the  place  of  provision  for  Depreciation." 


SINKING  FUNDS  273 


BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  XIV 

DICKINSON,    A.    L.     Interest    and    Sinking    Funds.     Accountant, 

XVII,  p.  715. 
DICKSEE,  L.  R.     Depreciation,  Reserves  and  Reserve  Funds,  pp. 

57-65.     London,  1903. 

SPRAGUE,  C.  E.    The  Accountancy  of  Investment.    New  York,  1904. 
TURNER,  S.  H.     Depreciation  and  Sinking  Funds  in  Municipal 

Undertakings.     Economic  Journal,  XIV,  pp.  47-56. 
WALTON,  S.     Sinking  Funds  and  Reserve  Accounts.     Journal  of 

Accountancy,  VI,  p.  394. 


CHAPTER    XV 

TRADING,    MANUFACTURING   AND   INCOME   ACCOUNTS 

THE  profits  of  a  year  can  be  accurately  shown  without 
an  elaborate  set  of  books,  all  that  is  necessary  being  a  care- 
fully prepared  annual  inventory.  The  herdsman  telling 
the  tale  of  his  sheep,  the  miser  counting  over  his  hoard, 
compares  the  figures  of  a  preceding  period  and  learns  what 
has  been  his  annual  increase.  The  contribution  which 
double  entry  bookkeeping  has  made  to  accounting  science 
is  largely  that  it  has  introduced  a  separate  Profit  and  Loss 
account  which,  though  it  may  not  show  the  net  results 
any  more  accurately,  does  present  them  in  greater  detail. 
Even  the  simpler  forms  of  the  Profit  and  Loss  account 
exhibit  such  details  as  the  gain  from  merchandise,  the 
amount  of  expenses,  the  interest  paid  or  received,  wages, 
rent,  and  other  sources  of  profit  and  lines  of  expense. 
With  greater  complexity  of  business  organization  there 
comes  a  demand  for  a  more  logical,  or  at  least  a  more 
practical  classification  of  Profit  and  Loss  items.  Account- 
ing practice  of  to-day  subdivides  the  old  Profit  and  Loss 
account  into  several  sections  or  even  into  separate  ledger 
accounts  which  not  merely  show  the  total  profits,  but  group 
the  items  so  as  to  exhibit  the  results  of  each  of  the  parts  or 
processes  which  are  embraced  in  the  operations  of  the  busi- 
ness. The  Trading  Account,  the  Manufacturing  Account 
and  the  highly  developed  Income  or  Revenue  account  of 
railroads  are  differentiations  of  the  simple  Profit  and  Loss 
account  and  are  appropriately  discussed  in  this  place. 

The  Trading  account,  as  the  term  is  ordinarily  used,  is 

274 


TKADING    AND   INCOME   ACCOUNTS          275 

a  technical  device  whereby  it  is  sought  to  differentiate 
the  elements  of  gain  caused  directly  by  trafficking,  from 
that  which  a  mercantile  establishment  derives  from  other 
sources.  At  the  outset  the  student  is  confronted  with  the 
difficulty  that  here,  as  elsewhere  in  accounting,  terminol- 
ogy is  but  partly  crystallized  and  the  words  are  used  loosely 
and  with  divergent  connotation.  Even  yet  it  is  difficult 
to  say  whether  the  Profit  and  Loss  account  is  a  compre- 
hensive statement  of  which  the  Trading  account  is  one 
part,  or  whether  they  are  separate  accounts,  or  whether 
one  should  rather  speak  of  a  Trading  Section  and  a  Profit 
and  Loss  Section  of  a  not  definitely  named,  all-embracing 
statement  of  the  results  of  the  business.  Furthermore 
while  there  is  general  agreement  that  the  Trading  Section 
—if  so  it  be  called— should  logically  be  separated  from 
other  exhibits  of  Profit  and  Loss,  there  is  no  agreement 
as  to  just  what  items  should  be  included  in  that  exhibit. 
These  confusing  differences  are  best  illustrated  by  discuss- 
ing a  sample  form,  that  given  by  Lisle  in  his  "  Account- 
ing ' '  being  particularly  elaborate  may  be  used  as  the  basis 
of  comparison.  The  form  with  only  a  few  verbal  changes 
is  given  on  pages  276-277. 

It  should  be  noted  first,  that  while  the  statement  as  a 
whole  is  called  the  Profit  and  Loss  account,  yet  the  second, 
third  and  fourth  sections  are  specifically  Profit  and  Loss 
accounts  in  contradistinction  to  the  first  section  called 
Trading  Account.  Other  accountants  make  a  wider  sepa- 
ration between  the  first  and  the  subsequent  sections,  and 
apply  Profit  and  Loss  account  only  to  the  latter  group. 
Again  variance  is  found  in  the  subdivisions  made  after 
the  Trading  Account.  Lisle  gives  three  subdivisions,  one 
showing  business  transactions,  with  a  balance  "  Profits  on 
ordinary  business  ' ' ;  the  second  containing  those  entries 
which  relate  to  the  investment  of  capital,  with  a  balance 
"  Net  Profits  ";  the  last  giving  the  allocation  of  profits. 
19 


276 


MODEKN   ACCOUNTING 


Dr. 


FORM  107. 
Profit  and  Loss  Account. 

1ST    SECTION TRADING    ACCOUNT. 


Cr. 


To  Cost  of  goods  used  (in- 
cluding freight  inward 
and  after  deducting 
purely  trade  discounts) . . 
"  Expenditure  directly  con- 
nected with  sales  or 
which  reduces  the  price 
realized  for  the  goods 
such  as: 

Commission  and  sala- 
ries of  travelers  and 
travelers'  expenses. . 
Wages  of  salesmen .... 

Wages  of  porters 

Outgoing  freight 

Cash  discount  allowed 

on  sales 

"  Balance     carried     down 
being  gross  profits 


By  Sales    (after    deducting 
purely  trade  discounts) 


2D     SECTION — ORDINARY     BUSINESS     PROFIT    AND     LOSS    ACCOUNT. 


To  Fixed  Charges  not  directly 
connected  with  sales  and 
not  varjung  much  with 
the  turnover  such  as: 

Rents,  taxes,  etc 

Repairs      and      other 

office  expenses.     ... 

Salaries  of  office  staff 

and  management. . . 

Depreciation 

:'  Business  losses  such  as  : 

Bad  debts   

Defalcations 

'  Balance  carried  down 
being  Profit  on  ordi- 
nary business 


By  Balance  brought    down 

being  Gross  Profits 

"    Income  not  directly  con- 
nected with  sales  such  as 
Rent  of  stores  or  prem- 
ises let  to  tenants . . . 
Revenue   from  royal- 
ties 


TRADING   AND   INCOME   ACCOUNTS 


277 


3D    SECTION THE    NET    PROFIT   ACCOUNT. 


To  Expenses  connected  with 
Capital,  such  as: 

Interest  on  loans 

"  Balance    carried    down, 
being  Net  Profit 


By  Balance    brought   down 
being  Profit  on  ordinary 

business 

"    Income  connected  with 
capital  such  as: 

Revenue  from  invest- 
ments   

Interest  earned 

Cash  discounts  ob- 
tained which  depend 
on  the  amount  of 
capital  in  the  busi- 
ness. . 


4TH    SECTION THE    PROFIT    AND    LOSS    APPROPRIATION    ACCOUNT. 


To  Allocation  of  Profit: 

Interest  on  capital .... 
Profit  allocated  to  cap- 
ital  

"  Profit      unappropriated, 
carried  forward. . . 


By  Balance    brought  down 
being  Net  Profit   


So  minute  a  subdivision  of  the  Profit  and  Loss  account 
as  that  shown  above  is  rarely  found  in  accounting  practice. 
Frequently  there  is  no  distinct  separation  into  parts.  A 
grouping  of  the  items  in  an  inner  column,  and  the  intro- 
duction of  subtotals  in  the  main  column  enable  one  to 
pick  out  the  facts  which  by  Lisle  are  more  formally  pre- 
sented by  the  actual  balancing  of  the  various  sections.  It 
cannot  be  said  that  there  is  any  universally  recognized 
form ;  indeed  there  should  not  be,  for  a  system  of  account- 
ing must  be  flexible,  not  tied  down  to  any  set  formula,  if 
it  is  most  clearly  to  present  the  facts  essential  to  the  under- 


278  MODERN   ACCOUNTING 

standing  of  a  particular  establishment.  This  is  well  recog- 
nized by  accountants,  for  not  only  do  the  forms  used  by 
other  authors  differ  from  the  one  presented  above,  but  a 
glance  through  Lisle 's  most  valuable  book  shows  that  of 
the  dozen  forms  of  Trading  and  Profit  and  Loss  accounts 
which  he  gives,  no  two  are  identical  in  nomenclature,  sub- 
division and  grouping  of  individual  items. 

FORM  108. 

Gross  earnings  (whether  sales  of  products,  transportation 

earnings,  professional  earnings,  etc.) $ 

Deduct — Cost  of  Manufacture  or  Operation: 

(a)  Manufacture  (for  a  manufacturing  con- 

cern)  $ 

Labor 

Material 

General  Manufacturing  Expenses 

(b)  Cost    of    Operation   (for    concerns   not 

manufacturing) 

(Under  suitable  headings  according  to 
the  nature  of  the  business) $ $ 

Gross  Profits $ 

Other  Earnings 

Deduct — 

Expenses  of  sale  (manufacturing  business 

only) $ 

Expenses  of  management  (if  distinct  from 

operation) 


Net  Profits  from  Operation $. 

Deduct — 

Interest  on  Bonds $ 

Other  Fixed  Charges 

$. 

Surplus  for  year $. 

Extraordinary  Profits  (detailed) 

Surplus  brought  forward  from  preceding  year 


$. 

Deduct — 

Extraordinary  charges  not  applicable  to  the 

operations  of  the  year $ 

Interest  and  Dividends  on  Stocks 

Ji. 
Surplus  carried  forward $. 


TRADING  AND   INCOME   ACCOUNTS 


279 


A  simpler  form,  suitable  for  general  application  is  that 
suggested  by  Mr.  A.  Lowes  Dickinson  at  the  Congress  of 
Accountants,  and  given  on  the  preceding  page. 

The  Manufacturing  account  is  a  further  amplification 
of  the  Trading  account  of  concerns  which  manufacture, 
rather  than  purchase,  part  or  all  of  their  stock  in  trade. 
The  Trading  account  includes  as  its  first  item  the  cost  of 
purchased  merchandise;  where  merchandise  is  manufac- 
tured the  manufacturing  account  gives  a  detailed  exhibit 
of  the  manufacturing  cost  of  the  commodities,  which  are 
then  entered  in  the  Trading  account  and  subsequently 
treated  just  as  if  they  had  been  purchased.  Difficulties 
exist  in  determining  what  items  belong  in  the  Manufac- 
turing Account  similar  to  those  confronting  one  who  forms 
a  Trading  Account.  In  both  cases  divergencies  in  practice 
rightfully  occur. 

An  example  of  a  manufacturing  account  is  as  follows: 

FORM  109. 
Manufacturing  Account.1 


All    direct    cost    of    Manu- 
facturing such  as: 

Raw  materials 

Labor 

Superintendence 

Packing  materials 

Heat  and  Power 

Factory  expenses 

Freight  (inward) 

Cartage  (inward) 

Insurance  on  Plant  .... 
Depreciation,  Machinery 

and  Tools 

Reserve  for  Taxes    on 

plant 


All    reductions    in    cost    of 
manufacturing  such  as: 
Discounts  on  Purchases. 

Inventories 

Balance  to  Trading  Account, 
representing  Manufactur- 
ing Cost  of  goods  sold. . . . 


» For  the  above  form  the  author  is  indebted  to  Mr.  E.  P.  Moxey, 
Jr.,  G.P.A. 


280  MODERN  ACCOUNTING 

The  Income  or  Revenue  Account  of  a  railroad  is  iden- 
tical  with  the  expanded  profit  and  loss  statements  already 
described,  so  far  as  the  difference  in  the  business  transacted 
permits.  Two  forms  for  such  an  account  are  given  below : 

FORM  110. 
Income  Account. 


Gross  earnings  from  operation. 
Less  operating  expenses 

Income  from  operation . . . 

Deficit 

Dividends  on  stocks  owned. . . 

Interest  on  bonds  owned 

Miscellaneous  income. . 


Income  from  other  sources 

Total  income 

Deficit 

Deductions  from  income: 

Interest  on  funded  debt  accrued 

Interest  on  interest-bearing  current  liabilities,  etc. 

Interest  on  real  estate  mortgages 

Rents  paid  for  lease  of  road 

Taxes 

Permanent  improvements 

Other  deductions 

Total  deductions  from  income 

Net  income 

Deficit 

Dividends, per  cent,  common  stock 

Dividends, per  cent,  preferred  stock 

Other  payments  from  net  income 

Total 

Surplus  from  operations  of  year  ending  June  30,  1907. 
Deficit  from  operations  of  year  ending  June  30,  1907. . 


Surplus  on  June  30,  1906  [from  "General  balance  sheet," 
1906  Report]. 

Deficit  on  June  30,  1906  [from  "General  balance  sheet,'* 
1906  Report] 

Additions  for  year 

Deductions  for  year 

Surplus  on  June -30,  1907  [for  entry  on  "General  balance 
sheet"] 

Deficit  on  June  30,  1907  [for  entry  on  "General  balance 
sheet"] 


281 


INCOME  ACCOUNT  (Abridged) 

OPERATING  INCOME: 

Railway  operating  revenues $102,358,892.95 

Railway  operating  expenses 61,713,161 .02 

Net  revenue  from  railway  opera- 
tions   $40,645,731.93 

Railway  tax  accruals $4,449,290.83 

Uncollectible  railway  revenues 9,547 . 58      4,458,838 . 41 

Total  operating  income $36,186,893 .52 

NONOPERATINQ  INCOME! 

Rent $1,300,396.92 

Dividend  income 10,554 .05 

Income  from  funded  securities 39,520 .88 

Income  from  unfunded  securities. . . .  1,029,259 .92 

Income  from  sinking  fund 2,900 . 10 

Miscellaneous  income 11,519 .97 

Total  nonoperating  income 2,394,151 .84 

Gross  income $38,581,045 . 36 

DEDUCTIONS  FROM  GROSS  INCOME: 

Rents $1,585,311 .43 

Miscellaneous  tax  accruals 13,165 .26 

Separately  operated  properties — Loss  41,887 . 85 

Interest  on  funded  debt 7  038,490 .72 

Amortization  of  discount  on  funded 

debt 55,163.52 

Miscellaneous  income  charges 756.60 

Total  deductions  from  gross  in- 
come   8,734,775.38 

Net  income $29,846,269 .98 

DISPOSITION  OF  NET  INCOME: 

Income  applied  to  sinking  funds $1,817,679 .41 

Dividend  appropriations  of  income. .       8,867,128.00 

Income  appropriated  for  investment 

in  physical  property 4,431,359 .81 

Fund  for  accrued  taxes — not  yet  due .       2,400,000 . 00 

Miscellaneous  appropriations  of  in- 
come   6,000,000.00 

Total  appropriations 23,516,167.22 

Income  balance  transferred  to 

credit  of  Profit  and  Loss. ....  $6,330,102 .70 


282  MODERN  ACCOUNTING 

Profit  and  Loss  Account. 
CREDITS: 

Credit  balance  at  beginning  of  fiscal  period $ 

Credit  balance  transferred  from  income 

Profit  on  road  and  equipment  sold 

Delayed  income  credits 

Unrefundable  overcharges 

Donations 

Miscellaneous  credits. . 


Total  credits . 


DEBITS: 

Debit  balance  at  beginning  of  fiscal  period $ 

Debit  balance  transferred  from  income 

Surplus  applied  to  sinking  and  other  reserve  funds 

Dividend  appropriations  of  surplus 

Surplus  appropriated  for  investment  in  physical 

property 

Stock  discount  extinguished  through  surplus .... 

Debt  discount  extinguished  through  surplus 

Miscellaneous  appropriations  of  surplus 

Loss  on  retired  road  and  equipment 

Delayed  income  debits 

Miscellaneous  debits. . 


Total  debits $ 

Balance  carried  to  Balance  Sheet $ 

The  first  of  the  above  forms  is  one  formerly  much  used 
by  American  railroads,  the  second  is  in  accordance  with  the 
improved  form  established  by  the  Interstate  Commerce 
Commission. 

In  discussing  the  variations  in  practice  one  ruling  prin- 
ciple is  to  be  kept  constantly  in  mind.  The  form  of  the 
Profit  and  Loss  statement  should  be  adapted  to  the  needs 
of  the  individual  establishment  and  cannot  be  prescribed 
by  any  hard  and  fast  rules.  Its  purpose  being  to  give  a 
better  insight  into  the  operations  of  the  establishment  to 


TRADING   AND   INCOME   ACCOUNTS          283 

the  end  of  enabling  the  managers  to  limit  waste  and  pre- 
vent unprofitable  ventures,  the  subdivisions  to  be  made 
and  the  decision  as  to  the  particular  section  into  which 
any  one  item  should  appear,  turn  largely  on  the  particular 
information  which  the  management  desires  to  secure,  and 
on  the  business  and  physical  organization  of  the  plant 
itself.  Thus,  for  instance,  of  two  manufacturing  estab- 
lishments one  may  be  considering  the  relative  desirability 
of  increasing  its  plant  or  of  purchasing,  from  other  manu- 
facturers, part  of  the  goods  it  sells.  The  other,  having  no 
opportunity  to  purchase  the  finished  commodities,  might, 
however,  consider  whether  it  is  better  to  continue  its  sales 
department  or  to  turn  its  entire  product  over  to  some  job- 
bing or  commission  house.  In  the  first  case  it  is  desirable 
to  show  the  exact  cost  of  manufacture,  to  compare  it  with 
the  price  at  which  goods  can  be  purchased  elsewhere;  in 
the  other  the  point  of  emphasis  is  the  cost  connected  with 
selling.  It  is  quite  conceivable  that  the  system  of  account- 
ing which  best  brought  out  one  set  of  figures  would  not 
most  economically  give  the  information  desired  in  the  sec- 
ond establishment. 

Again,  the  nature  of  the  organization  itself  is  a  factor 
in  determining  the  form  of  accounting.  The  separation 
or  juxtaposition  of  the  factory  and  the  office,  the  location 
of  the  warehouses  at  one  or  the  other  place,  the  degree  to 
which  the  labor  of  employees  is  specialized,  and  the  num- 
ber of  branch  establishments  are  'all  examples  of  facts 
which  enter  into  the  question  of  the  proper  grouping  of 
items.  What  is  desired  is  to  be  able  to  put  the  finger  on 
some  point  and  say,  "  Here  there  is  relative  inefficiency." 
If  manufacturing  is  distinct  from  trading,  the  separation 
of  the  two  in  the  accounts  seems  to  facilitate  the  localixa- 
tion  of  responsibility ;  if  the  two  are  combined,  but  there 
are  separate  plants  each  manufacturing  and  selling,  the 
line  of  cleavage  is  evidently  different.  As  in  all  account- 


284 


MODERN   ACCOUNTING 


ing  matters,  while  certain  general  principles  hold  good, 
the  main  difficulty  is  their  application  to  a  particular 
problem  which  must  be  individual  and  perhaps  unique. 

Keeping  clearly  in  mind  the  limitations  of  the  preced- 
ing section  the  points  of  more  general  interest  may  still 
be  discussed.  1.  The  first  problem  relates  to  the  valuation 
at  which  manufactured  goods  are  to  be  carried  down  to 
the  Trading  section,  where  these  sections  are  kept  separate. 

Two  distinct  principles  are  advanced  on  this  point. 
The  first  is  that  the  manufactured  goods  should  be  carried 
down  to  the  Trading  Account  at  the  net  manufacturing 
cost.  This  is  shown  in  Form  109.  The  other  is  that  goods 
should  be  transferred  from  the  Manufacturing  Account  to 
the  Trading  Account,  not  at  the  actual  cost  but  at  a  fair 
market  price,  that  is,  at  the  figure  which  would  have  been 
paid  had  the  goods  been  bought  from  some  other  manu- 
facturer instead  of  being  produced  within  the  establish- 
ment. In  favor  of  the  latter  view  it  is  urged  that  by  so 
doing  a  distinct  showing  is  made  of  the  profits  which 
result  from  efficient  manufacturing,  as  distinguished  from 
the  profits  which  arise  from  skillful  trading. 


Dr. 


FORM  112.  . 
Manufacturing  Account. 


Cr. 


To  Costs $100,000 

"  Manufacturing  Profits      10,000 

$110,000 


By  Trading  Account  . . .  $110,000 


Dr. 


Trading  Account. 


$110,000 


Cr. 


To  Merchandise  at  Trade 

Price $110000 

**  Expenses 15,000 

M  Trading  Profits 20,000 

$145,000 


By  Sales $145,000 


$145,000 


TRADING   AND   INCOME   ACCOUNTS           28f 

This  may  be  illustrated  by  assuming  a  manufactory 
which  produces,  at  a  net  cost  of  $100,000,  goods  for  which 
the  current  wholesale  price  is  $110,000;  and  that  these 
goods  are  sold  at  $145,000,  with  trading  expenses  of 
$15,000.  If  the  manufactured  goods  are  carried  to  the 
Trading  Account  at  the  market  rather  than  at  the  cost 
price,  the  accounts  appear  as  on  the  preceding  page. 

This  exhibits  Manufacturing  Profits  of  $10,000  and 
Trading  Profits  of  $20,000,  while  if  the  merchandise  had 
been  brought  down  at  the  cost  of  manufacture  there  would 
be  shown  only  a  single  item  of  profit  of  $30,000. 

The  advantage  of  distinguishing  between  the  two  ele- 
ments of  profit  is  indisputable,  especially  where  the  con- 
cern purchases  part  and  manufactures  part  of  the  mer- 
chandise which  it  sells.  But  in  so  far  as  the  goods  are  not 
all  sold  during  the  year  in  which  they  are  manufactured, 
there  is  the  great  objection  that  there  is  introduced  into 
the  accounts  an  unrealized  and  perhaps  fictitious  profit  on 


Dr. 


FORM  113. 
Manufacturing  Account. 


Cr. 


To  Cost  of  manufacture..  $100,000 
"  Manufacturing  Profits     10,000 

$110,000 


By  Trading  Account  at 

market  price $110,000 

$110,000 


Dr. 


Trading  Account. 


Cr. 


To  Manufacturing  Ac- 

By Sales  $72,500 

count  

$110,000 

Less  stock  on  hand  .  . 

55,000 

"  Cost  of  goods  sold  .  .  . 
"  Expenses  

.    $55,000 
15  000 

"  Trading  Profits.  .... 

2,500 

$72,500 

$72,500 

286  MODERN   ACCOUNTING 

the  unsold  portion  of  manufactured  goods.  This  is  illus« 
trated  by  assuming  that  only  one  half  of  the  manufactured 
goods  are  sold  for  $72,500.  "Where  goods  are  carried  down 
to  the  Trading  Account  at  cost  there  will  be  shown  Net 
Profits  of  $7,500.  But  where  goods  are  brought  down  at 
the  market  price  the  accounts  will  appear  as  in  Form  113, 
giving  a  total  profit  of  $12,500  instead  of  only  $7,500. 
The  difference,  of  course,  is  due  to  taking  credit  in  the 
latter  method  for  $5,000  profits  on  the  unsold  half  of  the 
product. 

The  problem  here  is  the  same  one  that  arises  when  in- 
ventorying any  merchandise,  namely:  Shall  stock  on  hand 
be  taken  at  cost  or  at  market  price  ?  As  has  been  shown  in 
Chapter  V,  the  taking  of  a  higher  market  price  is  gener- 
ally condemned  as  opening  the  doors  to  imaginary  profits. 
The  criticism  applies  to  the  taking  of  an  assumed  manu- 
facturing profit  as  well  as  to  the  profit  taken  on  still  un- 
sold merchandise  purchased.  But  there  is  a  real  advan- 
tage in  showing  the  manufacturing  as  distinct  from  the 
trading  profits,  in  that  it  gives  information  which  serves 
as  a  guide  for  future  management.  And  the  objection  to 
showing  the  unrealized  profit  may  not  be  conclusive,  for 
it  is  possible  to  put  the  profits  thus  shown  into  a  special 
reserve,  thus  removing  them  from  the  sum  available  for 
dividends  and  lessening  the  danger  of  overvaluation.  As 
has  been  shown,  valuation  at  the  present  market  price  is 
in  reality  the  logical  course  in  accounting,  but  in  ordinary 
cases  logical  consistency  is  sacrificed  as  a  practical  expe- 
dient to  prevent  overvaluation.  In  treating  the  Manufac- 
turing Account,  the  real  advantage  of  distinguishing  the 
part  of  the  profits  derived  from  manufacturing  is  so  great 
as  to  lead  many  accountants  to  return  to  the  logical  scheme 
of  valuation,  elsewhere  abandoned  from  motives  of  con- 
servative prudence.  This  is  recommended  by  both  Dicksee 
and  the  "  Encyclopedia  of  Accounting."  It  is  a  case 


TRADING   AND   INCOME   ACCOUNTS          287 

where  advantages  are  to  be  weighed  against  dangers,  with 
the  additional  complication  of  logical  principles  pulling 
against  consistency  of  treatment. 

2.  A  second  problem  relates  to  the  items  to  be  included 
in  the  Trading  Account.  Ignoring  variations  in  mere  de- 
tail, two  divergent  customs  are  found.  One  includes  in 
the  Trading  Account  all  the  expenses  connected  with  traf- 
ficking as  distinct  from  the  general  expenses  of  manage- 
ment. This  is  the  principle  applied  in  Lisle 's  form  given 
above,  Form  107,  where  commissions  and  salaries  of  trav- 
eling salesmen,  wages  of  salesmen,  wages  of  porters,  etc., 
are  charged  to  the  Trading  Section.  The  second  more 
rigid  method  excludes  from  the  Trading  Account  all  items 
except  those  representing  the  direct  cost  price  and  the  net 
selling  price  of  the  goods  handled.  The  balance  then 
carried  down  is  generally  called  Gross  Trading  Profits, 
although,  strictly  speaking,  the  term  is  incorrect  and  the 
balance  itself  is  of  no  great  logical  significance.  Properly 
it  is  not  profits,  but  merely  the  sales  less  some,  but  not  all, 
of  the  cost  or  expense  of  making  the  sales.  Nevertheless 
there  are  advantages  in  making  a  comparison  of  cost  and 
selling  price  as  these  figures  lend  themselves  conveniently 
to  statistical  results.  A  merchant  generally  bases  his  sell- 
ing price  on  the  cost  price,  either  adding  a  given  percent- 
age, or  by  fixing  it  so  that  difference  between  cost  and 
selling  price  is  a  percentage  of  the  latter.  Thus,  where 
merchandise  is  bought  at  $1.20  a  yard,  the  price  may  be 
fixed  so  as  to  yield,  say,  25  per  cent.  "  profit,"  or  other- 
wise expressed  so  that  20  per  cent,  of  the  selling  price  will 
be  gross  profit,  that  is,  at  $1.50.  Basing  the  selling  price 
thus  on  the  prime  cost  is  almost  a  necessity,  for  the  trad- 
ing expenses  are  not  known  when  the  price  is  fixed,  while 
the  cost  is  easily  ascertained  through  the  invoices.  The 
keeping  of  the  accounts  thus  somewhat  parallel  with  actual 
business  processes  has  practical  advantages.  But  a  glance 


288  MODERN  ACCOUNTING 

at  the  various  forms  used  by  accountants  shows  at  once 
that  practice  is  far  from  uniform. 

If  items  other  than  the  direct  costs  are  to  be  included 
in  the  Trading  Account  the  criterion  by  which  selection 
is  to  be  made  offers  new  difficulty.  The  one  frequently 
followed  is  to  include  only  those  expenses  which  are  at 
least  roughly  proportionate  to  the  amount  of  goods  sold. 
But  this  line  of  division  is  most  vague,  and  custom,  while 
including  wages  of  salesmen  and  commissions  to  travelers, 
excludes  the  wages  of  bookkeepers,  which  equally  may  vary 
with  the  amount  of  business  transacted. 

3.  "What  constitutes  selling  price  is  another  problem, 
for  at  times  it  is  difficult  to  determine  whether  a  given 
charge  is  a  deduction  from  the  selling  price  or  a  part 
either  of  the  selling  or  of  the  general  administrative  ex- 
penses.    The  discounts  allowed  on  sales  come  under  this 
class  of  doubtful  items.    Custom  seems  to  favor  deducting 
from  the  sales  the  trade  discounts,  that  is,  those  deduc- 
tions conventionally  allowed  to  dealers  from  the  nominal 
selling  price.     On  the  other  hand,  the  discount  allowed 
for  an  early  payment  of  the  account,  according  to  Lisle, 
should  not  be  deducted  from  sales,  but  be  treated  as  is 
interest  and  discount  paid  the  bank,  that  is,  as  a  cost  of 
obtaining  the  needed  working  capital.    Thus  it  results  that 
the  difference  between  the  nominal  selling  price  and  that 
actually  received  may  appear  in  either  one  of  three  sections 
of  the  Profit  and  Loss  statement;  in  the  first  as  a  deduc- 
tion from  sales,  in  the  second  as  a  selling  expense,  or  in  a 
subsequent  one  as  the  cost  of  borrowed  capital. 

4.  Of  greater  theoretical,  but  of  less  practical  interest 
is  the  location  of  taxes.    This  is  shown  clearly  in  the  case 
of  railroads.     Some  roads,  as  for  instance  the  Southern 
Railway  and  the  Illinois  Central,  treat  taxes  as  being  co- 
ordinate with  Operating  Expenses  and  deduct  them  from 
Gross  Earnings.    Others  treat  them  as  fixed  charges,  simi- 


TRADING   AND   INCOME   ACCOUNTS          289 

lar  to  interest,  and  deduct  them  from  the  Net  rather  than 
from  the  Gross  Earnings.  The  revised  form  proposed  by 
the  Interstate  Commerce  Commission  makes  a  special  divi- 
sion for  taxes,  as  is  shown  in  form  111,  and  still  other 
accountants  argue  that  taxes  should  be  treated  as  part  of 
the  Net  Profits. 

It  is  impossible  to  say  that  any  one  of  these  views  is 
absolute  and  exclusive.  Perhaps  even  the  system  of  taxa- 
tion may  influence  the  decision  as  to  the  proper  treatment 
of  taxes  in  accounts.  A  strong  argument  can  be  made  in 
favor  of  the  view  that  taxes  are  really  a  part  of  profits 
and  not  a  deduction  from  earnings  to  be  made  before 
determining  profits.  In  so  far  as  the  stockholder  is  con- 
cerned it  turns  on  two  facts:  whether  the  taxation  of  the 
road  exempts  the  stockholders  from  other  taxation;  and 
whether  the  capitalist  would  escape  taxation  on  other  in- 
vestments. If  the  stockholder  has  his  dividends  lessened 
by  the  taxes  paid,  but  in  all  probability  would  pay  no 
taxes  were  his  funds  invested,  say,  in  bonds  or  mortgages, 
the  taxes  are,  from  his  point  of  view,  in  no  sense  a  distri- 
bution of  profits.  But  where  there  is  an  income  tax  uni- 
formly enforced,  and  the  payment  of  taxes  by  the  road 
works  merely  as  a  stoppage  of  that  part  of  the  income,  it 
is  not  illogical  to  consider  the  tax  as  a  distribution  of  part 
of  the  Net  Profits  derived  from  operating  the  road. 

5.  Of  much  greater  importance  is  the  treatment  of 
depreciation.  In  a  preceding  chapter  it  was  shown  that 
depreciation,  despite  conflicting  usage  and  authority,  is  a 
charge  which  should  invariably  be  made.  Here  the  ques- 
tion is  as  to  the  section  of  the  Profit  and  Loss  Account — 
using  the  title  in  its  broadest  sense — in  which  depreciation 
should  appear.  Almost  all  possible  combinations  are  found 
even  in  the  relatively  few  accounts  in  which  depreciation 
shows  at  all.  In  some  few  cases  it  is  subtracted  from 
Gross  Earnings,  and  thus,  like  expenses,  is  prior  to  the 


290  MODERN   ACCOUNTING 

determination  of  Net  Earnings.  This  is  done  for  instance 
by  the  National  Biscuit  Company.  By  some,  for  instance 
the  Chicago  City  Railway  Company,  it  is  even  distinctly 
included  among  the  expenses.,  Much  more  frequently  it 
is  subtracted  from  Net  Earnings,  in  which  place  it  may 
rank  along  with  dividends  or  may  be  regarded  as  one  of 
the  fixed  charges;  since  in  many  accounts  fixed  charges, 
depreciation,  dividends,  and  reserves  are  all  together  sub- 
tracted from  "  Net  Earnings  "  without  any  intermediate 
balancing  to  indicate  how  much  of  the  net  earnings  are  at 
the  same  time  "  Net  Profits."  An  example  of  this  treat- 
ment is  found  in  the  accounts  of  the  International  Mercan- 
tile Marine  Company.  In  still  other  companies  the  deduc- 
tion is  clearly  made  from  what  is  called  Net  Profits,  that 
is,  it  is  deducted,  together  with  dividends,  from  the  balance 
remaining  after  fixed  charges  have  been  met.  This  is  done 
by  the  Republic  Iron  and  Steel  Company.  And  finally 
the  Diamond  Match  and  numerous  other  companies  sub- 
tract depreciation  from  the  surplus  after  the  dividends 
have  been  paid.  Depreciation  charges  are  thus  variously 
regarded  as  partaking  of  the  nature  of  expense,  of  fixed 
charges,  of  profits  reserved  or  placed  in  a  surplus.  In 
railroads  depreciation  has  almost  never  been  specifically 
allowed.  The  recent  ruling  of  the  Interstate  Commerce 
Committee  referred  to  above  demands,  however,  that  it  be 
included,  at  least  so  far  as  equipment  is  concerned,  among 
the  operating  expenses. 

Those  who  have  followed  the  argument  of  this  treatise 
will  agree  that  it  is  a  radical  error  to  treat  depreciation  as 
anything  else  than  a  deduction  to  be  made  before  profits 
are  ascertained,  and  that,  allowing  for  variations  in  the 
use  of  terms,  it  must  inexorably  appear  in  the  Income  Ac- 
count before  the  balance  called  Net  Income  is  reached. 
But  so  far  as  shown  by  the  published  accounts  only  about 
one  third  of  the  corporations  making  any  allowance  for  de- 


TKADING   AND   INCOME   ACCOUNTS          291 

preciation  deduct  it  before  obtaining  the  sum  which— by 
whatever  name  it  is  called— is  apparently  available  for 
dividends.  The  strong  position  taken  by  the  Interstate 
Commerce  Commission  is  theoretically  correct,  for  depre- 
ciation is  really  an  expense.  In  the  formal  statements  of 
manufacturing  concerns  depreciation  of  the  plant  should 
appear  in  the  Manufacturing  Account,  the  depreciation  of 
office  and  store  equipment  in  the  Trading  Account  rather 
than  among  the  fixed  charges  as  a  deduction  from  Net, 
Earnings. 

Even  to  treat  depreciation  as  a  fixed  charge,  though 
that  is  a  great  improvement  over  regarding  it  as  an 
optional  disposition  of  profits,  is  illogical.  Depreciation 
represents  an  expense  not  only  preceding  profit  to  the 
stockholders  as  such,  but  prior  also  to  the  earnings  on 
the  invested  capital  as  a  whole,  whether  that  capital  is 
represented  by  bonds  or  stock.  Whether  a  road  costing 
$100,000,000  is  financed  by  issuing  $100,000,000  stock,  or 
by  issuing  only  half  that  sum  in  stock  and  an  equal  amount 
in  bonds,  the  invested  capital  (using  capital  in  the  eco- 
nomic, not  in  the  accounting,  sense)  is  the  same,  and  the 
earnings  of  that  investment  should  appear  the  same  in  the 
Income  Account.  No  change  of  form  of  capitalization 
affects  these  earnings.  Interest  charges  may  increase,  but 
the  earnings  ceteris  paribus  remain  unchanged.  But  not  so 
with  depreciation.  A  smaller  charge  shows  indeed  larger 
apparent  earnings,  but  such  a  showing  is  false  and  decep- 
tive. Depreciation,  therefore,  is  not  logically  to  be  treated 
as  coordinate  with  interest  charges. 

It  is  even  more  erroneous  to  treat  the  fixed  charges- 
as  superior  to  depreciation.  Unquestionably  there  is  an 
insistence  about  interest  charges  which  appeals  to  the 
directors  in  a  way  in  which  a  charge  erroneously  called  a 
"mere  bookkeeping  charge  "  is  not  regarded.  But  the 
compulsion  to  make  a  payment  has  nothing  to  say  regard- 
20 


292  MODERN   ACCOUNTING 

ing  the  position  of  the  charge  in  the  Income  Account. 
Needed  repairs  may,  perhaps,  be  deferred  for  years,  while 
the  payment  of  a  collateral  note  is  imperative  and  un- 
avoidable. But  the  inclusion  of  repairs  among  expenses 
is  never  even  questioned,  while  the  payment  of  a  note  has 
no  place  whatever  in  the  Income  Account,  does  not  in  the 
least  affect  the  determination  of  profits.  A  sound  system 
of  accounting  will  therefore  not  make  depreciation  subse- 
quent to  fixed  charges  merely  because  of  the  imperative 
nature  of  the  latter  payments. 

Finally  placing  depreciation  charges  after  net  profits 
is  not  only  incorrect  in  theory,  but  tends  to  the  vicious 
policy  of  making  the  amount  of  depreciation  depend  on 
the  amount  of  profits  and  of  omitting  it  altogether  when 
there  are  no  net  profits  against  which  it  may  be  charged. 

BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  XV 

BROAKER,  F.  and  CHAPMAN,  R.  M.  The  American  Accountants' 
Manual,  I,  pp.  131-148.  New  York,  1897. 

CHAMPNESS,  C.  H.  Form  and  Arrangement  of  Profit  and  Loss 
Accounts.  Accountant,  XXIII,  1904. 

LISLE,  G.  Accounting  in  Theory  and  Practice,  pp.  55-63.  Edin- 
burgh, 1906. 

Manufacturers'  Accounts.  Article  hi  Encyclopedia  of  Account- 
ing, V,  pp.  1-5. 

Profit  and  Loss  Account.     Article,  Ibid.,  V,  p.  366. 

Revenue  Accounts  and  Balance  Sheets.  Encyclopedia  of  Account- 
ing, VIII,  pp.  249-326.  [Contains  an  interesting  collection  of 
Revenue  Accounts  of  British  companies.] 


CHAPTER    XVI 

COST  ACCOUNTS 

THE  desire  to  distinguish  between  the  elements  of  profit 
due  to  industrial  and  commercial  activities  respectively  led 
to  the  formulation  of  the  Manufacturing  and  Trading  Ac- 
counts. The  stress  of  modern  business  and  the  keenness 
of  competition  make  necessary  a  more  minute  analysis  and 
a  closer  estimate.  Not  only  must  it  be  known  what  are  the 
manufacturing  costs  as  a  whole,  but  these  must  be  so  ana- 
lyzed as  to  indicate  the  cost  of  each  commodity,  of  each 
process  employed  in  production,  even  of  each  part,  minute 
though  it  be,  of  which  the  commodity  is  composed.  Sys- 
tems designed  to  secure  such  information  are  known  as 
Cost  Accounts. 

The  attention  given  to  such  investigations  is  of  recent 
origin.  The  first  reference  to  its  desirability  is  said  to  be 
that  of  Charles  Babbage  in  his  "  Economy  of  Manufac- 
ture," published  in  1832,  but  half  a  century  elapsed  be- 
fore factory  managers  began  on  any  extended  scale  to 
introduce  systems  of  Cost  Accounts.  Since  then  increased 
attention  has  been  given  to  the  subject,  particularly  under 
the  influence  of  engineers,  to  whom,  rather  than  to  pro- 
fessional accountants,  the  credit  of  inaugurating  and  de- 
veloping cost  accounting  is  perhaps  due. 

More  specifically  the  purposes  of  cost  accounting  are 
as  follows : 

1.  To  indicate  the  probable  actual  cost  of  production 
so  as  to  enable  the  manufacturer  to  determine  the  price  at 
which  he  can  profitably  sell.  This  is  particularly  impor- 

293 


294  MODEKN  ACCOUNTING 

tant  in  engineering  work  where  so  much  is  done  on  con- 
tracts rather  than  by  producing  stock  goods  for  the  open 
market.  Thus,  for  instance,  a  system  of  cost  accounts, 
accurately  kept,  should  enable  a  shipbuilder  to  give  an 
estimate  of  the  cost  of  constructing  a  vessel  which  would 
be  something  more  than  guesswork. 

2.  Identical  in  principle  is  the  value  of  cost  accounts 
in    indicating   whether   the   manufacturer    shall    produce 
goods  for  the  open  market  where  the  price  is  already 
fixed  by  competition.     Without  such  information  manu- 
facturers have  undoubtedly  continued  to  produce  and  sell 
certain  lines  of  goods  which,  at  least  to  them,  were  un- 
remunerative  and  a  source  of  loss.     Perhaps  the  market 
price  is  fixed  by  some  competitor  whose  peculiar  advantage 
in  production  gives  profits  at  prices  unremunerative  to  less 
favored  rivals;  or  perhaps  the  price  is  due  to  ignorance 
on  the  part  of  the  competitors  who  are  themselves  selling 
at  a  loss  while  fancying  that  they  are  making  profits.    A 
clear  understanding  as  to  whether  the  manufacturer  can 
produce  so  as  to  realize  a  fair  profit  at  current  prices  is 
of  advantage  not  merely  to  the  individual,  but  also  to 
society,  as  it  serves  to  prevent  the  misdirection  of  capital 
and  the  great  loss  which  occurs  when  readjustment  be- 
comes necessary. 

3.  Cost  Accounts  have  a  further  advantage  in  deter- 
mining the  advisability  of  introducing  a  new  process,  or 
of  substituting  machine  for  hand  labor.    They  have  shown, 
for  instance,  that  it  is  profitable  to  run  a  drill  so  rapidly 
as  to  wear  it  out  in  a  single  day,  although  at  a  slower 
speed  it  would  have  drilled  twice  as  many  holes  before  de- 
struction.   They  show  at  what  prices  of  machinery  and  of 
skilled  labor  it  is  profitable  to  substitute  an  automatic 
machine  in  a  process  which  can  interchangeably  be  per- 
formed by  a  skilled  laborer  on  a  less  costly  machine.    Thus 
throughout  the  industrial  process  Cost  Accounts  substitute 


COST   ACCOUNTS  295 

facts  and  intelligence  for  the  rule  of  thumb  and  blind 
guessing. 

4.  Finally,  Cost  Accounts  furnish  a  convenient  method 
for  checking  the  efficiency  of  factory  management.  If  it 
appears  that  the  cost  of  producing  a  given  form  of  pinion 
has  increased,  it  enables  the  manager  at  once  to  locate  the 
cause.  It  may  be  that  the  change  is  unavoidable,  due  to- 
higher  cost  of  raw  material  or  higher  wages.  But,  on  the 
other  hand,  investigation  may  show  carelessness  on  the  part 
of  the  foreman,  and  ill-advised  redisposition  of  labor,  or 
wastefulness  in  the  handling  of  material — evils  which  are 
already  far  on  the  way  toward  correction  when  once  their 
existence  is  shown.  Slight  losses  of  this  kind  may  well 
escape  attention  if  only  general  results  are  studied ;  or  the 
losses  in  one  department  may  easily  be  offset — but  by  no 
means  canceled — by  a  new  economy  elsewhere.  The  sub- 
division of  accounts  makes  it  more  easy  to  detect  changes,, 
and  gives  a  constant  incentive  to  foremen  and  superin- 
tendents to  reduce  costs. 

The  discussion  of  Cost  Accounting  is  rendered  more 
difficult  by  the  rather  vague  and  varying  terminology  em- 
ployed. There  are  many  different  costs  depending  on  the 
point  of  view.  The  terms  used  to  designate  these  differing 
costs— Prime  Cost,  Factory  Cost,  Total  Cost,  etc.— are  not 
uniformly  defined  either  by  economists  or  accountants.  This 
may  be  illustrated  by  the  case  of  a  factory  which  desires  to 
learn  the  cost  of  producing,  say,  a  pair  of  shoes.  To  pro- 
duce this  the  following  factors  are  involved:  (1)  The  raw 
material  used.  (2)  The  wages  of  the  laborers  directly  em- 
ployed in  making  the  shoes.  (3)  The  expenses  of  operating 
the  factory  as  a  whole  which  are  not  particularly  assigned 
to  this  pair  of  shoes,  as  for  instance  the  wages  of  watchmen, 
the  repairs  on  the  building,  the  cost  of  the  power  used  for 
various  purposes,  etc.  (4)  The  expenses  of  the  establish- 
ment outside  of  the  factory.  (5)  More  questionably  the 


296  MODERN   ACCOUNTING 

normal  rate  of  profit,  whether  separated  or  not  from  the 
normal  rate  of  interest  on  invested  capital.  In  a  broad 
sense  profit  is  a  necessary  cost  of  the  permanent  continu- 
ance of  the  industry ;  for,  if  normal  profits  are  not  secured, 
new  factories  will  not  be  started,  and  an  adjustment  of 
prices  will  be  ultimately  secured  whereby  profits  as  well 
as  wages  will  be  covered  by  the  selling  price. 

By  some  writers  the  first  and  second  items  mentioned 
above  are  collectively  called  Prime  Cost,  while  the  first 
three  items  together  make  up  Factory  Cost.  Other  writers 
use  Prime  Cost  to  indicate  the  same  as  Factory  Cost  just 
defined,  and  these  employ  no  specific  term  to  indicate  the 
sum  of  the  cost  of  material  and  labor  directly  employed. 
The  sum  of  the  first  four  items  is  sometimes  called  Total 
Cost,  sometimes  "  Cost  to  make  and  sell."  Accountants 
universally  exclude  profits  from  cost,  but  use  as  a  compre- 
hensive term,  including  all  five  items  enumerated  above, 
the  phrase  "  Selling  Price."  In  addition  to  these  differ- 
ences in  terminology  there  is  divergence  in  regard  to  the 
treatment  of  certain  particular  items,  such  as  interest,  rent, 
taxes,  etc.,  involving  the  principles  discussed  in  Chapters 
IV  and  XV. 

"Without  attempting  to  decide  between  the  various 
usages,  each  of  which  has  the  support  of  high  authority, 
and  no  one  of  which  therefore  can  be  declared  wrong,  the 
real  problem  may  be  faced,  namely:  What  share  of  the 
total  expenses,  covering  as  they  do  the  production  of  vari- 
ous commodities,  is  to  be  assigned  to  the  cost  of  some  one 
commodity,  or  to  some  single  process?  As  to  the  first  two 
items,  wyages  and  material,  there  is  no  doubt  as  to  the  prin- 
ciple and  little  difficulty  in  practice.  The  material  actu- 
ally used  and  the  wages  of  laborers  directly  employed  in 
producing  the  given  commodity  are  obviously  an  integral 
part  of  the  cost  of  producing  that  article.  The  connection 
is  so  clear  that  the  use  of  the  phrase  Prime  Cost  seems  ia 


COST   ACCOUNTS  297 

a  measure  to  be  justified  in  describing  these  two  funda- 
mental and  easily  ascertainable  elements  of  cost. 

The  first  point  of  difficulty  comes  in  attempting  to  dis- 
tribute the  indirect  factory  costs  among  the  various  com- 
modities produced.  Various  principles  are  used,  among 
which  may  be  mentioned  the  following: 

1.  The  indirect  factory  expenses,  which  include  such 
items  as  wages  of  workmen  employed  in  general  labor  such 
as  watchmen,  cleaners,  firemen,  etc.,  the  wages  of  foremen 
and  superintendents,  light,  heat,  rent,  and  repairs  of  fac- 
tory and  its  equipment,  depreciation,  etc.,  are  apportioned 
among  the  various  jobs  or  processes  in  the  proportion 
which  in  some  particular  exists  between  the  given  job  and 
the  total  operations  of  the  factory.  But  the  basis  on  which 
the  comparison  is  made  is  variously  chosen,  and  it  may 
rest  either  on 

a.  The  direct  wages  paid. 

&.  The  hours  of  labor  spent. 

c.  The  material  used.  * 

d.  The  direct  wages  paid  plus  the  cost  of  material. 
(Prime  Cost.) 

e.  The  units  of  product. 

Other  bases  may  also  be  taken,  and  one  of  them,  the 
Machine  Rate,  is  reserved  for  further  discussion,  but  the 
five  mentioned  above  are  those  most  generally  used. 

Taking,  as  purely  arbitrary  figures,  those  given  below 
in  Form  114,  it  is  seen  that  each  of  the  methods  may  pro* 
duee  quite  different  results,  the  figure  in  the  last  column 
indicating  the  amount  of  the  total  'indirect  factory  ex- 
penses of  $12,000  to  be  apportioned  to  the  particular  job 
on  each  of  the  five  bases  of  distribution  mentioned. 

Doubtless  in  actual  practice  the  divergence  in  results 
reached  by  the  different  methods  would  not  be  so  great, 
as  in  the  figures  given  below.  But  it  is  clear  that  unless 
all  work  is  of  a  practically  uniform  character  the  costs 


298 


MODERN   ACCOUNTING 


obtained  must  vary  according  to  the  basis  of  distribution 
selected.  Unfortunately  for  scientific  accuracy  it  is  impos- 
.sible  to  pick  out  any  one  of  the  methods  named  as  being 
logically  correct  or  uniformly  accurate.  The  first  one, 
which  distributes  factory  expenses  in  proportion  to  direct 
wages  paid,  is  probably  more  frequently  used  than  any  of 
the  others.  It  is,  however,  obviously  incorrect  where  there 
is  great  divergence  in  rates  of  wages  paid,  or  where  there 
is  a  difference  in  the  degree  in  which  automatic  machinery 
is  used  in  the  various  processes.  But  it  is  simple  of  appli- 
cation, and  this  fact  in  itself  probably  explains  its  more 
general  use. 

FORM  114. 


BASIS  USED 

In  Entire 
Factory 

On  this 
Job 

Apportion- 
ment 

>(a)  Wages  paid  

$24,000 

$100 

$50  00 

(5)  Hours  of  labor     

60,000 

400 

80  00 

•(c)  Material  used.  .           

16000 

50 

37  50 

•(d)  Wages  plus  Material  

40,000 

150 

45  00 

•(e)  Units  produced  

400,000 

4,000 

120.00 

Distribution  in  proportion  to  hours  rather  than  to  cost, 
•of  labor  is  favored  on  the  ground  that  much  of  the  indi- 
rect cost,  such  as  foremen's  wages,  light,  heat,  etc.,  is  de- 
pendent on  the  hours  of  work,  and  that  other  general 
charges,  such  as  rent,  depreciation,  etc.,  have  a  direct  rela- 
tion to  time.  But  its  critics  point  out  the  fact  that  it 
makes  the  same  charge  upon  the  labor  of  a  boy  running 
a  fifty-dollar  machine  that  it  does  on  that  of  a  man  with 
a  thousand-dollar  machine,  "  the  grotesqueness  of  which 
procedure  will  not  be  enlarged  upon."  Apportionment  of 
indirect  factory  expenses  on  the  basis  either  of  material 
or  of  the  sum  of  wages  plus  material  has  the  obvious  ob- 
jection that  there  does  not  seem  to  be  any  logical  connec- 
tion between  an  increase  in  the  cost  of  material  used  and 


COST   ACCOUNTS  299 

an  added  charge  for  indirect  factory  costs.  Apportion- 
ment in  proportion  to  the  units  of  product  may  be  most 
convenient  of  application  in  certain  kinds  of  production, 
and  is  frequently  used  in  foundry  practice,  the  ease  with 
which  this  system  is  used  being  held  to  more  than  offset 
any  theoretical  objection  on  the  ground  of  the  absence  of 
strict  logical  accuracy. 

The  foregoing  methods  have  all  considered  wages  and 
material  as  the  only  charges  directly  apportionable  to  the 
particular  product  or  operation,  and  have  made  all  the 
indirect  charges  a  function  of  labor  or  material.  A  dif- 
ferent conception  is  one  which  recognizes  to  a  greater  or 
less  degree  that  in  modern  factory  production  there  is  a 
third  element  of  eost,  namely,  that  of  the  machinery  em- 
ployed. This  theory  has  had  various  applications.  In 
some  it  has  merely  determined  the  direct  cost  of  the  ma- 
chinery, including  depreciation,  repairs,  and  interest,  and 
from  this  obtained  an  hour-rate  by  dividing  the  total  of 
such  costs  by  the  assumed  number  of  hours  which  the 
machine  runs.  This  method,  of  course,  merely  gives  an 
apportionment  of  part  of  the  indirect  expenses  of  the  fac- 
tory and  leaves  probably  the  larger  part  still  to  be  allo- 
cated. Furthermore,  it  does  not  give  correct  results  where 
the  machinery  is  idle  for  part  of  the  time,  for  the  rate 
charged  is  on  the  basis  of  the  machine  running  the  assumed 
number  of  hours.  Sometimes  the  method  has  involved 
dividing  all  the  indirect  expenses  by  the  total  number  of 
hours  which  the  machines  run,v  or  are  supposed  to  run, 
thus  obtaining  a  uniform  hour-rate  without  differentiation 
between  different  classes  of  machines.  This  is  similar  to 
dividing  the  indirect  expenses  according  to  the  hours  of 
labor  spent  on  the  particular  operation,  the  difference 
being  that  in  one  case  the  hours  of  labor,  in  the  other  the 
hours  of  machine  operation,  are  taken  as  the  basis  of  dis- 
tribution. 


300  MODEKN   ACCOUNTING 

The  obvious  objection  here  is  that  many  of  the  indirect 
expenses  have  no  more  to  do  with  the  cost  of  running  the 
machines  than  they  have  to  do  with  wages  or  the  cost  of 
material.  For  instance,  in  a  factory  in  which  all  the  work 
was  done  by  hand  there  would  still  be  indirect  charges 
covering  the  cost  of  the  factory  itself,  the  watchmen,  light 
and  fuel  necessary  for  keeping  the  building  warm  in  win- 
ter. These  certainly  cannot  be  machine  costs,  where  no 
machinery  is  used,  and  part  of  similar  expenses  in  a  mod- 
ern factory  equally  relate  to  labor  rather  than  to  machin- 
ery. Or  again  some  of  the  indirect  expenses  relate  to  the 
material  used,  as,  for  instance,  the  additional  watchmen 
required  where  the  material  is  costly  and  portable  and 
hence  easily  stolen.  Probably  the  indirect  expenses  of  an 
establishment  for  polishing  diamonds  have  no  great  rela- 
tionship to  the  use  of  machinery. 

In  the  more  improved  methods  of  obtaining  machine 
rates  the  attempt  is  to  determine  not  merely  part,  but  all 
of  the  charges  which  attach  to  the  running  of  a  given 
machine,  and  to  make  an  hour-rate  which  correctly  dis- 
tributes all  such  expenses.  In  other  words  it  is  an  exten< 
sion  of  the  costing  system  to  the  operation  of  the  individual 
machines  themselves,  so  as  to  determine  scientifically  what 
is  the  real  cost  of  running  each  one  of  them  for  an  hour. 

This  system  has  been  strongly  advocated  by  A.  Hamil- 
ton Church,  who  outlines  it  as  follows: 

"  First  we  consider  each  machine  as  an  independent 
production  center,  allocating  to  such  centers  all  the  ex- 
penses and  charges  which  can  on  reasonable  analysis  be 
considered  as  chargeable  as  a  composite  rent  or  machine 
rate  for  all  the  factors  of  production  therein  concerned. 
Second,  we  charge  to  a  monthly  shop-charges  account  all 
charges  whatever  incurred  by  that  shop,  including  all  the 
items  specifically  represented  in  fractional  detail  by  the 
machine  rates,  and  also  including,  of  course,  such  general 


COST   ACCOUNTS  301 

items  as  cannot  be  represented  in  the  machine  rates,  of 
which  the  most  obvious  item  is  the  supervision  of  a  head 
or  foreman. 

"  Then  as  each  machine  is  occupied  on  jobs,  the  latter 
are  debited  with  so  much  per  hour  as  machine  rate,  and 
at  the  end  of  the  month  the  total  amount  so  earned  by 
the  machines  is  deducted  from  the  total  shop  expenses, 
leaving  a  balance  which  is  distributed  over  the  same  jobs 
as  a  supplementary  rate.  The  ratio  of  the  supplementary 
rate  to  the  amount  distributed  by  the  machine  rates  forms 
a  varying  barometer  whose  fluctuation  is  an  index  of  the 
efficiency  of  the  shop. 

"  It  will  of  course  be  obvious  that  when  the  machines 
are  all  running  full  time  the  supplementary  rate  will  con- 
sist of  the  general  charges  alone,  such  as  the  foreman's 
wages,  which  have  not  any  individual  connection  with  the 
particular  machines.  This  will  be  the  condition  of  maxi- 
mum efficiency  in  the  shop.  In  proportion  as  all  machines 
are  not  kept  full  of  work  all  the  time,  this  ratio  of  the 
supplementary  rate  to  the  amount  distributed  by  the  ma- 
chine rates  will  begin  to  rise.  The  same  effect  will  occur 
if  any  general  kind  of  expenditure  is  increased. ' ' 1 

In  determining  the  special  hour-rate  to  be  applied  to 
a  given  machine  the  following  method  is  advocated  by 
Church.  First  the  costs  of  the  factory  building  as  such 
are  determined.  These  include  interest,  insurance,  depre- 
ciation and  repairs  on  the  building,  ground  rent,  if  any, 
and  taxes  on  the  real  estate.  All  these  expenses  are  appor- 
tioned between  the  various  machines  on  the  basis  of  the 
floor  space  occupied.  This  rate  may  be  further  varied  by 
distinguishing  between  space  occupied  in  one  or  another 
part  of  the  building.  Second,  the  cost  of  lighting  is  de- 
termined, which  is  also  distributed  according  to  floor 
space  where  there  is  general  overhead  lighting,  with  spe- 

1  Engineering  Magazine,  XXI,  909. 


302  MODERN   ACCOUNTING 

cial  charges  for  individual  lights  for  a  particular  machine. 
Third,  the  cost  of  power,  which  includes  fuel,  boiler  and 
engine  costs,  wages  of  firemen  and  engineers,  etc.,  all  of 
which  is  reduced  to  a  rate  per  horse-power  hour,  which 
is  then  charged  to  each  machine  on  the  basis  of  the  esti- 
mated power  used  by  each  machine.  Fourth,  the  cost  of 
the  machine  itself,  which  as  before  stated  includes  interest, 
depreciation,  etc.,  and  all  of  which  is  apportioned  accord- 
ing to  the  estimated  annual  working  hours.1  The  several 
factors  just  enumerated  give  a  machine-hour  rate,  differ- 
ent for  each  type  of  machine,  which  is  supposed  with  some 
degree  of  accuracy  to  cover  all  the  costs  of  operating  that 
machine,  assuming  that  the  machine  is  fully  occupied. 
But  it  still  leaves  two  elements  of  indirect  cost  not  yet 
apportioned.  One  of  these  covers  the  general  expenses  of 
the  factory  which  cannot  with  any  show  of  reason  be  con- 
sidered part  of  the  cost  of  operating  the  machine,  and  the 
other  that  element  of  expense  which  remains  unappor- 
tioned  because  the  machines  are  not  run  to  their  full  esti- 
mated capacity. 

It  is  apparent,  therefore,  that  even  the  elaborate  scheme 
of  machine  costs  proposed  by  Church  does  not  entirely 
remove  the  problem  as  to  the  distribution  of  indirect  fac- 
tory costs.  It  has,  however,  made  that  problem  of  much 
less  practical  importance,  for  instead  of  considering  all  the 
expenses  over  and  above  the  wages  and  cost  of  material  as 
indirect  expenses,  the  apportionment  of  which  must  be 
largely  by  a  crude  and  unscientific  ratio,  the  bulk  of  the 
general  factory  expenses  are  found  to  be  directly  attrib- 
utable to  particular  jobs  through  the  machine  rate,  and 
there  remains  as  unallocated  expenses  only  the  two  items 
mentioned  in  the  last  paragraph — those  by  nature  not  as- 
signable to  a  machine  rate,  and  those  due  to  idle  plant. 

The  treatment  of  the  unassignable  expenses  is  relatively 

1  Engineering  Magazine,  XXII,  31  ff. 


COST   ACCOUNTS 


303 


unimportant,  for  it  cannot  constitute  a  very  large  propor- 
tion of  the  total  expenses.  Church  suggests  that  the  appor- 
tionment be  on  the  basis  of  the  hours  spent  on  the  various 
jobs.  But  where  there  is  a  considerable  margin  due  to  idle 
plant  the  apportionment  of  this  sum  is  of  some  theoretic 
interest. 

The  illustration  given  by  Church  assumes  a  factory 
with  four  machines  on  which  the  machine  rate  was  based 
on  the  assumption  that  thej"  would  each  work  200  hours, 
the  rate  charged  to  each  machine  being  40,  30,  20  and  10 
cents  respectively.  Had  each  of  the  machines  been  used 
for  the  full  assumed  time  the  charges  would  have  covered 
the  total  indirect  expenses  of  $200,  but  because  of  idleness 
there  remains  a  balance  of  unassigned  charges  amounting 
to  $58,  the  charges  to  each  machine  being  as  shown  below : 

FORM  115. 


MACHINE 

Time  used 

Rate  per 
Hour 

Amount 
Charged 

A  . 

120 

$0.40 

$48.00 

B      

134 

0  30 

40.20 

c     

169 

0.20 

33.80 

D  

200 

0.10 

20.00 

623 

$142.00 

In  this  case,  the  author  argues,  the  $58  may  either  be 
apportioned  on  the  basis  of  the  hours  employed,  making  a 
supplementary  rate  of  9|  cents  per  hour,  or  on  the  basis 
of  the  amount  of  the  machine  charges,  making  a  supple- 
mentary rate  of  40.8  per  cent,  (ibid.,  xxii,  910).  "Which- 
ever method  is  used,  the  result  is  that  the  cost  of  produc- 
tion is  increased  because  of  the  idle  machines. 

To  this  some  critics  vigorously  object.  If  the  costs  are 
taken  as  the  basis  for  making  estimates,  or  bids,  it  leads 
to  the  illogical  result  that  at  the  very  time  when,  because 


304  MODERN  ACCOUNTING 

of  an  idle  factory,  it  is  most  desirable  to  get  new  work, 
the  accounts  will  show  that  the  work  cannot  profitably 
be  done  except  at  a  price  higher  than  normal.  Whit- 
more,  writing  in  the  Journal  of  Accountancy,  therefore 
urges  that  these  costs  representing  idle  time  should  not  be 
charged  up  against  the  goods  produced.  In  his  opinion 
they  should  be  put  in  "a  separate  account  which  would  be 
treated  as  a  general  expense  of  the  establishment,  not  as 
part  of  the  immediate  cost  of  manufacturing.  But  the 
practical  results  are  the  same  whether  supplementary 
charges  are  treated  as  Whitmore  suggests  or  are  all  dis- 
tributed over  the  goods  produced.  So  long  as  the  elements 
representing  idle  machines  are  shown  in  a  supplementary 
rate,  attention  is  clearly  drawn  to  the  loss  that  comes  from 
idle  plant.  There  is  the  same  incentive  to  try  for  new 
business  whether  that  loss  appears  among  the  manufac- 
turing costs  or  is  separately  shown  as  one  of  the  general 
expenses  of  the  establishment. 

A  vital  difference  in  method  of  estimating  cost  turns 
on  the  point  whether  the  indirect  factory  expenses  which 
are  apportioned  to  different  jobs  are  the  actual  expenses 
incurred  during  the  period  in  which  the  operations  are 
performed,  or  whether  they  are  to  be  based  on  the  experi- 
ences of  past  operations.  For  instance,  in  a  given  factory 
it  may  be  desirable  to  treat  the  indirect  costs  as  a  per- 
centage to  be  added  to  the  prime  cost.  This  may  be  done 
by  taking  account,  say,  at  the  end  of  each  month  of  all 
such  expenses  and  accurately  apportioning  them  to  the 
work  then  in  progress.  But  others,  as  for  instance  Oberlin 
Smith  and  Nisbet,  recommend  that  the  added  charge  be 
based  on  the  experience  of  a  preceding  year,  or  series  of 
years,  so  that  the  charge  can  at  any  time  be  made  without 
waiting  for  the  results  of  the  current  period. 

To  some  it  seems  that  by  taking  the  current  figures  a 
greater  degree  of  accuracy  is  obtained.  But  it  should  be 


COST   ACCOUNTS  305 

remembered  that  for  certain  purposes  what  is  desired  is 
not  so  much  the  actual  amount  which  it  cost  to  produce  a 
certain  commodity,  as  an  estimate  of  what  it  will  cost  to 
produce  more  of  the  same  kind  of  goods.  This  is  particu- 
larly true  where  special  contracts  are  undertaken.  Just 
wrhat  experience  will  give  the  best  indication  of  future 
costs  may  be  debatable.  It  does  not  necessarily  follow  that 
the  experience  of  the  present  month  is  any  better  criterion 
than  that  of  last  year. 

The  distribution  of  general  establishment  charges  offers 
somewhat  similar  difficulties.  These  expenses  include  the 
office  expenses,  the  expenses  of  selling,  and  the  general 
expenses  of  financing  and  managing  the  whole  enterprise. 
Alternative  methods  of  dividing  these  expenses  among  the 
products  are  to  apportion  them  in  proportion  to: 

1.  The  Wages  Cost. 

2.  The  Factory  cost,  i.  e.,  the  cost  of  wages,  material 
and  the  indirect  factory  expenses,  or 

3.  The  hours  consumed  in  manufacturing  the  product. 

4.  The  selling  price. 

The  second  method  seems  the  most  logical,  for  it  appar- 
ently covers  all  the  elements  for  which  the  establishment 
exists.  Church,  however,  advocates  employing  the  hours  as 
the  basis,  making,  however,  certain  modifications  in  the 
rates  charged  to  different  classes  of  commodities. 

In  the  preceding  pages  have  been  discussed  the  prob- 
lems concerning  the  distribution  of  indirect  charges  jn  gen- 
eral. Further  difficulties  arise  in  reference  to  the  appor- 
tionment of  certain  special  costs.  One  of  these,  relating 
to  the  cost  of  patterns,  requires  particular  mention.  Not 
only  is  there  the  general  question  as  to  how  far  the  costs 
of  designing  and  making  patterns  should  be  charged  to 
expense,  and  how  far  the  patterns  should  be  considered 
an  asset,  but  there  is  a  further  difficulty.  After  having 
decided  that  a  given  amount  is  really  an  expense,  is  it  to 


306  MODEKN   ACCOUNTING 

be  allocated  to  the  particular  products  made  from  the 
pattern  or  treated  as  a  general  expense  of  the  factory? 
This  is  particularly  clear  where  unsuccessful  patterns  or 
designs  are  made.  Are  these  all  to  be  charged  against  the 
cost  of  the  article  made  from  a  later  satisfactory  model, 
or  do  the  preliminary  attempts  represent  merely  general 
expenses  of  the  factory  as  such?  Somewhat  similarly:  is 
the  cost  of  making  a  special  pattern  for  an  article  made 
on  contract  to  be  considered  as  cost  of  completing  the 
contract  or  is  there  a  residual  value  representing  the 
serviceability  of  that  same  pattern  for  future  possible 
contracts  ? 

Three  points  of  uncertainty  arise  even  in  regard  to  the 
best  system  of  cost  accounting.  1.  The  first  is  whether  the 
information  acquired  is  after  all  worth  the  expense  of 
acquiring  it.  This  is  more  than  doubtful  in  some  of  the 
more  elaborate  and  expensive  systems  of  cost  keeping  that 
are  occasionally  introduced.  To  take  a  flagrant  and  noto- 
rious case  the  cost  system  introduced  into  the  Government 
Printing  Office  seems  to  have  cost  decidedly  more  than  it 
was  worth.  In  this  instance  the  committee  investigating 
the  system  reported  that  it  ' '  is  principally  to  be  criticised 
upon  the  score  that  in  an  attempt  to  secure  all  classes  of 
detail,  the  amount  of  labor  entailed  upon  each  employee 
for  the  purpose  of  recording  necessary  facts,  and  the 
amount  of  labor  required  for  subsequent  tabulation,  were 
so  great  as  to  make  the  system  almost  prohibitive. ' ' 1 

2.  The  second  point  of  doubt  is  as  to  the  degree  of 
accuracy  which  may  be  obtained  and  the  danger  which 
arises  from  treating  as  actual  what  is  merely  hypothetical. 
It  has  been  shown  that  even  the  division  between  the  Manu- 
facturing Account  and  the  other  portions  of  the  Profit 
and  Loss  Account  is  with  difficulty  drawn  and  can  never 
be  regarded  as  of  absolute  value.  Much  more  is  it  true 

»  LX  Cong.  1.  Seas.  H.  Doc.  974,  p.  IL 


COST   ACCOUNTS  307 

that  the  detailed  apportionment  of  expenses  among  the  dif- 
ferent processes  or  the  various  commodities  is  to  some  ex- 
tent a  matter  of  estimate.  To  be  sure  accounts  can  be 
prepared,  though  with  great  difficulty  and  much  expense, 
in  which  every  cent  expended  will  be  allocated  to  some 
vunit  of  product.  But  it  must  be  remembered  that  this  rests 
on  estimates  which  can  never  be  exact.  To  illustrate:  It 
is  difficult  to  determine  the  exact  cost  of  power  in  a  fac- 
tory. Coal  and  wages  may  be  known,  but  depreciation  of 
plant  is  an  estimate  merely.  But  granting  a  substantial 
accuracy  as  to  the  cost  of  the  total  power  this  can  be 
divided  to  the  last  cent  by  some  system  of  machine  rates. 
But  much  of  this  ostensible  accuracy  is  specious.  It  is  a 
rough  estimate  at  best  which  attempts  to  divide  the  horse 
power  among  the  different  machines,  and  the  degree  of 
accuracy  obtained  in  the  final  results  can  never  surmount 
this  fundamental  defect.  And  the  whole  system  of  fixing 
the  machine  rate  depends  on  an  incorrect  estimate  of  the 
hours  during  which  the  machine  will  be  at  work.  As  Bur- 
ton said,  "  Cost  accounts  based  on  separate  charges  for 
each  machine  employed  must  be  generally  hypothetical, 
and  in  many  if  not  the  majority  of  eases  they  must  be 
delusively  hypothetical. ' ' 

3.  A  third  point  bears  on  the  application  which  is  to- 
be  made  of  the  result.  Are  they  to  be  used  in  determining 
whether  capital  shall  go  into  a  given  industry?  If  so,  it 
is  evident  that  what  is  wanted  is  a  correct  estimate  of  the 
net  income  after  deducting  all  interest  on  capital  and  other 
items  frequently,  indeed  generally,  excluded  from  the  cost 
accounts  themselves.  The  information  necessary  to  show 
whether  an  enterprise  is  ultimately  successful  is  very  dif- 
ferent from  that  which  shows  whether  an  enterprise  once 
established  should  be  continued.  Cost  accounts  as  they  are 
frequently  prepared  confuse  these  two  points  of  view. 
Thus  Whitmore  criticises  the  inclusion  of  idle-machine  cost 
21 


308  MODEKN   ACCOUNTING 

as  not  showing  whether  to  a  new  concern  it  is  desirable  to 
undertake  certain  work.  The  idle-machine  cost,  says  he, 
Jg  incidental  to  the  establishment  of  a  new  concern  and 
should  not  be  included  in  an  estimate  which  shows  whether 
goods  can  be  produced  profitably  at  a  certain  price.  But 
the  same  author  includes  interest  on  the  cost  of  machines 
and  buildings  in  his  estimate  of  machine  costs,  while  these 
have  nothing  to  do  with  the  cost  of  producing  further 
goods  by  a  factory  already  established.  As  is  well  known 
in  railroad  practice,  when  a  road  is  once  permanently  con- 
stiucted  it  is  better  to  carry  freight  at  a  price  not  cover- 
ing interest  than  to  refuse  traffic.  The  same  principle,  of 
course,  applies  to  a  factory.  If,  as  seems  to  be  the  opinion 
in  discussing  idle-plant  costs,  the  purpose  of  the  cost  ac- 
count is  to  show  the  figure  at  which  the  established  factory 
can  afford  to  produce,  it  is  clearly  illogical  to  include  in 
this  figure  interest,  which  indeed  bears  on  the  ultimate 
profitableness  of  the  enterprise,  but  not  on  the  desirability 
of  undertaking  a  given  contract. 

As  to  the  technic  of  cost  accounting  little  can  here  be' 
said.  It  is  impossible  to  frame  a  system  of  cost  accounting 
applicable  to  establishments  of  different  character.  Iron 
works  producing  a  single  form  of  staple  commodity,  a  fac- 
tory making  a  few  standard  grades  of  cloth,  each  involving 
a  succession  of  separate  processes,  works  manufacturing 
special  machines  where  it  is  desirable  to  learn  the  cost  of 
the  entire  machine  and  of  each  of  its  parts,  and  a  shipyard 
undertaking  special  contracts,  each  needs  an  entirely  dif- 
ferent system  of  keeping  its  cost  accounts.  No  general 
scheme  of  forms  can  be  outlined  which  will  apply  to  all 
of  them.  Nor  can  a  scheme  be  outlined  which  will  apply 
in  detail  to  the  different  individual  establishments  of  a 
single  class. of  undertakings.  As  Dicksee  has  said: 

"  It  need  hardly  be  pointed  out  that  the  requirements 
of  undertakings  carrying  on  a  similar  business  are  by  no 


COST   ACCOUNTS  309 

means  uniform.  Special  and  local  considerations  have  to 
be  taken  into  account,  and  the  most  desirable  system  for 
any  particular  undertaking  can  only  be  ascertained  after  a 
full  and  detailed  inquiry  has  been  made  into  its  peculiar 
circumstances  and  conditions. ' ' x 

Even  to  describe  a  system  serviceable  to  a  particular 
establishment,  while  it  might  have  illustrative  and  suggest- 
ive value,  would  require  so  extended  a  treatment  as  to 
exclude  it  from  a  treatise  on  the  general  principles  of 
modern  accounting. 

The  best  that  can  be  done  is  to  call  attention  to  some  of 
the  most  elementary  matters  of  the  technic  of  cost  account- 
ing, referring  the  reader  to  the  more  extended  treatises  on 
cost  accounting,  as  indicated  in  the  bibliographical  note 
appended  to  this  chapter,  for  more  detailed  information, 
or  better  still  to  emphasize  the  necessity  of  employing  a 
technical  expert  to  arrange  a  system  of  cost  accounting 
adapted  to  the  particular  needs  of  a  given  establishment. 

Cost  accounting,  as  shown  above,  requires  (1)  an  accu- 
rate recording  of  the  wages  directly  paid,  (2)  of  the  ma- 
terial consumed,  and  (3)  a  systematic  allocation  of  the 
indirect  factory  and  establishment  charges  incurred  in  con- 
nection with  each  contract,  process  or  product.  To  keep 
track  of  the  direct  wages  it  is  evidently  necessary  to  have 
a  daily  record  kept  showing  the  exact  nature  of  the  work 
on  which  each  laborer  is  employed.  Only  by  such  an  elab- 
orate system  can  the  proper  amount  be  charged  to  the 
separate  accounts  representing  the  direct  wages  cost  of  the 
particular  contract  or  process.  From  these  daily  individ- 
ual slips  can  be  prepared  a  summary  of  wages  showing  by 
individuals  or  departments  the  total  direct  wages  charge. 
Sheets  ruled  in  columns  representing  the  various  subdi- 
visions will  most  conveniently  serve  for  such  records. 

The  material  consumed  needs  similar  treatment.    Here, 

1  Advanced  Accounting,  p.  232. 


810  MODERN  ACCOUNTING 

however,  it  is  well  to  emphasize  the  need  for  careful  rec- 
ords, as  the  keeping  track  of  materials  used  is  generally  not 
so  accurately  done  as  in  the  case  of  wages  paid.  Strangely 
enough  accountants  who  require  the  pay  roll  to  balance  to 
the  last  cent  pay  little  attention  to  the  accuracy  of  the 
accounts  representing  material  consumed.  A  discrepancy 
in  the  cash  drawer  excites  immediate  attention  while  valu- 
able material  and  finished  parts  are  often  treated  with 
carelessness  and  no  exact  balancing  is  expected  of  the  store- 
keeper. The  first  requisite  is,  therefore,  a  more  careful 
accounting  for  the  materials  as  well  as  for  the  cash  in  the 
drawer,  an  accuracy  regarding  amount  of  material  used 
not  dissimilar  to  that  required  in  regard  to  wages  paid. 

Where  the  materials  are  directly  .purchased  for  a  par- 
ticular contract  this  is  simply  done,  and  probably  with 
greater  accuracy  than  where  material  on  hand  is  taken 
from  the  warehouse  for  a  similar  purpose.  Again  the  fic- 
tion that  the  cash  directly  paid  out  is  more  important  than 
a  similar  value  of  other  assets  is  seen  to  affect  accounting 
methods. 

It  is  in  the  treatment  of  stores  that  the  greatest  im- 
provements have  been  introduced.  In  any  system  of  ade- 
quate cost  accounting  it  is  now  recognized  that  it  is  neces- 
sary to  keep  accurate  track  of  all  goods  coming  into  the 
stores,  of  all  goods  issued  for  different  jobs,  or  all  returned 
goods  not  needed  for  the  job  for  which  they  were  originally 
issued.  In  this  way  it  is  possible  (1)  to  verify  the  amount 
of  goods  on  hand  at  any  time  and  so  prevent  peculation 
and  waste,  and  (2)  to  keep  account  of  the  material  actu- 
ally used  in  each  job.  Model  forms  of  a  stores  record 
sheet,  and  a  requisition  are  given  on  pages  311  and  312. 
From  the  slips  regarding  the  wages  and  materials  con- 
sumed, and  from  similar  records  showing  the  machine 
rates,  the  proper  entries  can  be  made  in  a  ledger  account 
opened  for  each  job.  These  ledger  accounts  are  most  con- 


2    Q 


312 


MODERN   ACCOUNTING 


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314  MODERN  ACCOUNTING 

veniently  kept  in  loose  leaf  ledgers,  ruled  somewhat  as  iit 
Form  118.  On  the  same  sheet  may  be  entered  the  sup- 
plementary charges  and  such  other  information  as  may  be 
desired. 

The  forms  given  above  apply  particularly  to  an  estab- 
lishment where  it  is  desired  to  ascertain  the  cost  of  special 
contracts.  Where  machines,  for  instance,  are  being  made 
for  stock,  or  where  merchandise  such  as  cloth  is  being  simi- 
larly made,  the  items,  for  which  columns  are  to  be  ruled, 
in  the  Cost  Ledger  Accounts  would  of  course  vary.  The 
cost  account  of  the  finished  machine  would  probably  indi- 
cate not  the  labor,  and  material  and  machine  rates  as  a 
whole,  but  rather  the  total  cost  of  the  several  parts  mak- 
ing up  the  machine.  The  cost  of  the  cloth  would  not  be 
divided  into  wages  and  material  but  into  the  costs  of  the 
several  processes  involved  in  making  the  finished  product. 
In  each  case  the  elements  must  be  combined  so  as  to 
give  most  easily  the  information  wanted  in  the  particular 
factory. 

In  many  of  the  forms  used  great  economy  is  secured 
by  the  use  of  duplicating  devices,  so  that,  for  instance,  the 
filling  out  in  triplicate  of  an  order  for  stores  will  provide 
an  order  to  the  storekeeper,  a  memorandum  for  the  fore- 
man issuing  the  order,  and  a  memorandum  for  the  cost 
accountant  whereby  the  proper  entry  can  be  made  in  his 
records. 

BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  XVI 

ARNOLD,  H.  L.    The  Factory  Manager  and  Accountant.    New  York, 
1903.     [Gives  description  of  systems  of  cost  accounting  used 
in  various  factories.] 
—  The  Complete  Cost-Keeper.     New  York,  1900. 

BEAN,  B.  C.     The  Cost  of  Production.     New  York,  1905. 

BURTON,  F.  G.    Engineers'  and  Shipbuilders'  Accounts.    London, 
1902. 


COST   ACCOUNTS  315 

CHURCH,  A.  H.  The  Proper  Distribution  of  Expense  Burden.  New 
York,  1908.  [An  elaborate  presentation  of  the  "improved 
machine  cost "  system  and  a  criticism  of  other  systems  of  cost 
accounting.] 

DAY,  C.  M.  Accounting  Practice.  New  York,  1908.  [A  valuable 
technical  treatise,  containing  numerous  forms.] 

EDHIS,  W.  C.  and  TINDALL,  W.  B.  Manufacturers'  Accounts. 
Toronto,  1904. 

GARCKE,  E.  and  FELLS,  J.  M.  Factory  accounts.  Fifth  edition. 
London,  1902.  [A  pioneer  work  on  the  subject  and  still 
standard.] 

HALL,  H.  L.  C.     Manufacturing  Cost.     Detroit,  1904. 

HAWKINS,  L.  W.     Cost  Accounts.     London,  1905. 

WEBNER,  F.  E.  Obtaining  Actual  Knowledge  of  the  Cost  of  Pro- 
duction. Engineering  Magazine,  XXXV-XXXVI. 

WHITMORE,  J.  Factory  Accounting  as  Applied  to  Machine  Shops. 
Journal  of  Accountancy,  II,  pp.  248,  345,  430,  III,  p.  20,  106, 
211. 

FOR  FURTHER  BIBLIOGRAPHY,  SEE: 
Encyclopaedia  of  Accounting,  II,  p.  299. 
Engineering  Magazine,  XXVII,  p.  645. 

The  Accountants'  Library,  London,  a  series  of  some  forty  volumes 
treating  of  special  branches  of  accounting  gives  many  forms 
applicable  to  the  particular  needs  of  various  classes  of  estab- 
lishments. 


CHAPTER   XVII 

PARTNERSHIP   ACCOUNTS 

PARTNERSHIP  accounts  constitute  no  separate  system  of 
accounting.  Whether  the  proprietorship  is  vested  in  one 
or  more  persons  the  general  principle  of  double  entry 
bookkeeping,  that  there  is  an  equation  between  the  sum 
of  the  Proprietorship  accounts  and  the  sum  of  the  Goods 
accounts,  holds  true.  The  mere  subdivision  of  the  pro- 
prietorship into  various  accounts  introduces  no  new  prin- 
ciple. 

The  essential  problems  of  partnership  are  those  which 
bear  upon  the  essential  character  of  the  partnership  rela- 
tion and  refer  to  the  proper  division  to  be  made  of  profits 
and  losses,  of  assets  and  liabilities.  If  it  is  clearly  under- 
stood in  each  case  just  what  contract  has  been  made  there 
is  ordinarily  little  difficulty  in  formulating  the  accounts. 
But,  unfortunately,  the  terms  of  partnership  agreements 
are  at  times  vague,  and  even  the  courts  have  not  always 
agreed  on  their  interpretation.  Some  of  the  cases  in  which 
difficulties  arise  are  therefore  of  importance  to  the  account- 
ant even  though  there  may  be  no  really  vital  accounting 
principle  at  stake. 

The  first  class  of  difficulties  arises  in  connection  with 
the  establishment  of  the  firm.  When  an  individual  first 
opens  a  set  of  books  there  either  is  no  difficulty  in  know- 
ing how  much  capital  he  contributes,  or  if  there  be  a  doubt 
it  is  of  no  particular  moment  so  far  as  it  concerns  ultimate 
distribution  of  wealth.  If  A  begins  business  with  $5,000 
cash  and  certain  real  estate  he  should,  of  course,  attempt 

316 


PARTNERSHIP   ACCOUNTS 


317 


to  place  correct  valuation  on  the  latter  in  estimating  his 
net  wealth.  But  if  he  fails  to  do  so  it  evidently  does  him- 
self no  injury.  But  if  two  persons  join  in  a  partnership, 
one  furnishing  cash  and  the  other  real  estate,  it  is  neces- 
sary to  know  what  value  is  placed  on  the  latter.  To  be 
sure  the  original  entry  is  the  same  whether  it  be  in  the 
books  of  a  single  trader  or  those  of  a  partnership,  as  in 
either  case  Real  Estate  is  debited  and  the  Capital  account 
of  the  one  contributing  it  is  credited.  This  may  be  illus- 
trated by  assuming  the  following  opening: 


Dr. 


FORM  119. 
Balance  Sheet. 


Cr. 


Cash $5,000 

Real  Estate. 5,000 

$10,000 


A,  Capital  Account $5,000 

B,  Capital  Account 5,000 

$10,000 


in  which  the  cash  is  contributed  by  A  and  the  real  estate 
by  B.  Any  other  valuation  of  the  real  estate  would  not, 
in  itself  affect  the  credit  of  A's  Capital  account;  nor 
would  it,  in  the  absence  of  special  agreement,  affect  the 
division  of  profits,  B  being  entitled  to  half  of  the  profits 
whatever  the  value  of  his  contribution.  But  the  value  at 
which  the  contributed  property  is  admitted  is,  neverthe- 
less, of  vital  importance  in  a  partnership  for  having  once 
been  accepted  by  the  firm  any  subsequent  shrinkage  in  the 
value  of  the  real  estate  is  a  loss  to  be  divided  between  the 
two  partners,  and  not  one  to  be  borne  by  the  contributing 
partner  alone.  Conversely  a  sale  of  the  real  estate  for  $10,- 
000  gives  to  A  as  well  as  to  B  one  half  of  the  appreciation, 
$2,500.  It  is  evident  then  that  it  is  essential  in  account- 
ing to  understand  the  nature  of  the  contribution  which 
each  partner  makes,  to  interpret  accurately  the  terms  of 
the  partnership  agreement,  for  "  in  the  absence  of  special 


318 


MODEEN   ACCOUNTING 


agreement  the  rise  or  fall  in  the  value  of  fixed  plant  or 
real  estate  belonging  to  a  partnership  is  as  much  profit  or 
loss  of  the  partnership  as  anything  else."  (Robinson  v. 
Ashton,  L.  R.  20  Eq.  28  (1875)). 

In  this  connection  it  is  necessary  to  distinguish  between 
the  division  of  profits  and  a  share  in  the  partnership. 
This  may  be  illustrated  by  the  case  where  a  single  trader 
whose  Balance  Sheet  shows: 


Dr. 


FORM  120. 

Balance  Sheet. 


Cr. 


Merchandise $5,000      Capital  Account 


$5,000 


and  who  agrees  to  admit  B  and  give  him  one  half  of  the 
profits  if  he  contributes  $6,000.  This  done  the  Balance 
Sheet  shows: 

FORM  121. 
Dr.  Balance  Sheet  of  A  and  B.  Cr. 


Merchandise $5,000 

Cash 6,000 

$11,000 


A,  Capital  Account $5,000 

B,  Capital  Account 6,000 

$11,000 


The  basis  of  the  division  of  the  profits  here  differs  from 
the  proportion  of  capital  contributed  by  each,  which  is 
legal  and  not  uncommon  in  practice.  But  had  the  agree- 
ment been  that  the  contribution  of  $6,000  by  B  entitled 
him  to  a  half  interest  in  the  business  the  accounts  would 
need  different  treatment.  The  half  interest  being  secured 
by  a  contribution  of  $6,000  it  implies  that  A  too  has  a 
similar  interest  of  $6,000  and  consequently,  accepting  the 
valuation  of  the  goods  at  $5,000  as  correct,  that  he  is  con- 
strued as  contributing  Goodwill  of  $1,000  as  well  as  the 
merchandise,  thus  giving: 


PARTNERSHIP   ACCOUNTS 


319 


Dr. 


FORM  122. 

Balance  Sheet  of  A  and  B. 


Cr. 


Merchandise $5,000 

Goodwill 1,000 

Cash 6,000 

$12,000 


A,  Capital  Account $6,000 

B,  Capital  Account 6,000 


$12,000 


If  desired  the  same  relationship  can  be  represented  with 
Goodwill  eliminated  as  follows : 


Dr. 


FORM  123. 
Balance  Sheet  of  A  and  B. 


Cr. 


Merchandise $5,000 

Cash 6,000 

$11,000 


A,  Capital  Account $5,500 

B,  Capital  Account 5,500 

$11,000 


Similarly  if  the  arrangement  specifies  that  B's  contribu- 
tion of  $6,000  gives  him  a  three  fifths  interest  in  the  busi- 
ness, not  merely  three  fifths  of  the  profits,  and  the  mer- 
chandise still  being  accepted  as  worth  $5,000,  B  must  be 
construed  as  bringing  into  the  firm  business  connections, 
or  other  elements  of  Goodwill,  to  such  a  value  that  his 
total  contribution  represents  one  and  a  half  times  the  value 
of  A's  merchandise,  or: 


Dr. 


FORM  124. 
Balance  Sheet  of  A  and  B. 


Cr. 


Merchandise $5,000 

Goodwill 1,500 

Cash 6,000 

$12,500 


A,  Capital  Account $5,000 

B,  Capital  Account 7,500 


$12,500 


or  again  eliminating  the  Goodwill: 


320 


MODERN   ACCOUNTING 


Dr. 


FORM  125. 
Balance  Sheet  of  A  and  B. 


Cr. 


Merchandise $5,000 

Cash 6,000 

$11,000 


A,  Capital  Account $4,400 

B,  Capital  Account 6,600 

$11,000 


The  first  point  in  partnership  accounting  to  be  ascertained 
is  then  what  is  the  exact  nature  of  the  partnership  agree- 
ment ;  what  is  actually  contributed ;  what  is  the  division  of 
interests  between  the  partners. 

It  is  also  necessary  to  distinguish  between  one  who 
buys,  say,  a  third  interest  in  a  firm  from  the  members  of 
the  firm  and  one  who  enters  the  partnership  with  a  third 
interest.  Thus  if  A  and  B  are  in  business  together  with 
the  following  showing: 

FORM  126. 
Dr.  Balance  Sheet  of  A  and  B.  Cr. 


Miscellaneous  assets $60,000 


$60,000 


A,  Capital  Account $20,000 

B,  Capital  Account 40,000 

$60,000 


C  might,  if  it  were  mutually  agreed  on,  buy  a  third  inter- 
est in  the  firm  from  B,  paying  therefor  $20,000,  which 
would  give  as  the  Balance  Sheet  of  the  new  firm: 


Dr. 


FORM  127. 
Balance  Sheet  of  A,  B,  and  C. 


Cr. 


Miscellaneous  assets $60,000 


$60,000 


A,  Capital  Account $20,000 

B,  Capital  Account 20,000 

C,  Capital  Account 20,000 

$60,000 


But  if  he  were  admitted  to  the  firm  with  a  one  third  inter- 


PAKTNEKSHIP   ACCOUNTS 


321 


est  the  showing,  provided  he  contributed  the  book  value  of 
his  share  in  the  business,  would  have  to  be  as  follows: 


Dr. 


FORM  128. 
Balance  Sheet  of  A,  B,  and  C. 


Cr. 


Miscellaneous  Assets $60,000 

Cash 30,000 


$90,000 


A,  Capital  Account $20,000 

B,  Capital  Account 40,000 

C,  Capital  Account 30,000 

$90,000 


This  important  distinction  has  not  always  been  observed 
by  writers,  as  may  be  seen  even  in  Dicksee's  work  on 
Goodwill. 

The  allowance  of  interest  on  partners'  capital  furnishes 
opportunity  for  disagreement,  principally  when  the  exact 
nature  of  the  allowance  is  not  definitely  stated  in  the  arti- 
cles. If  interest  is  to  be  allowed  on  the  entire  capital  the 
matter  is  simple.  Thus  assuming  partners  who  contribute 
as  follows :  A  $100,000,  B  $60,000  and  C  $50,000,  interest 
at  5  per  cent,  to  be  allowed  and  profits  shared  equally,  the 
several  accounts  concerned  will  be  as  in  Form  129. 

The  same  net  results,  so  far  as  the  partners'  balances 
are  concerned,  may  be  secured  by  crediting  or  debiting 
interest  on  the  excess  or  deficit  which  each  partner's  con- 
tribution shows  in  relation  to  the  average  capital.  The 
three  partners  have  together  furnished  $210,000,  of  which 
the  average  is  one  third  or  $70,000.  A  receives  interest 
on  an  excess  of  $30,000,  B  is  charged  on  a  deficit  of  $10,000 
and  G  on  $20,000,  which  gives  the  same  balances  to  the 
credit  of  the  several  partners  as  those  in  Form  129,  but 
without  passing  the  charge  through  the  interest  or  profit 
and  loss  account.  The  correct  booking  in  this  case  could 
be  secured  by  the  following  journal  entry: 


B. 
C.. 


$500 

1,000 

To  A $1,500 


322 


MODEKN   ACCOUNTING 


Dr. 


FORM  129. 
A,  Capital  Account. 


Or. 


§  of  interest  allowed. . . 
Balance 


. .      $3,500 
. .    101,500 


$105,000 


Cash $100,000 

Interest  on  $100,000  at 

5% 5,000 

$105,000 


Balance $101,500 


Dr. 


B,  Capital  Account. 


Cr. 


$  of  interest  allowed. 
Balance. . 


$3,500 
59,500 

$63,000 


Cash $60,000 

Interest   on   $60,000   at 

5% 3,000 

$63,000 


Balance $59,500 


Dr. 


C,  Capital  Account. 


Cr. 


J  of  interest  allowed. 
Balance 


$3,500 
49,000 

$52,500 


Cash $50,000 

Interest   on   $50,000   at 

5% 2,500 

$52,500 


Balance $49,000 


Dr. 


Interest  Account. 


Cr. 


Allowed  on  partners' 
capital: 

A $5,000 

B 3,000 

C 2,500   $10,500 

$10,500 


By  A $3,500 

'r  B 3,500 

"   C 3,500 


$10,500 


NOTE. — As  these  accounts  are  to  show  only  the  effect  of  the  interest 
transactions  the  Interest  Account  has  been  closed  directly  into  the 
Capital  Accounts  instead  of  being  carried  to  the  Profit  and  Loss  account 
and  appearing  indirectly  in  the  balance  of  Profit  and  Loss  carried  to  the 
partners 


PARTNERSHIP   ACCOUNTS  323 

It  is  to  be  noted  that  had  the  basis  of  profit  sharing 
not  been  one  third  to  each  but  in  some  other  proportion, 
say,  2:1:1,  the  basis  of  comparison,  by  which  excess  con- 
tributions are  measured,  would  be  correspondingly  modi- 
fied. Thus  A's  contribution  being  compared  with  two 
fourths  of  $210,000  or  $105,000  he  is  charged  with  interest 
on  $5,000  or  $250;  B  showing  an  excess  of  $7,500  over 
$52,500  (i.  e.,  one  fourth  of  $210,000)  receives  $375;  and 
C  pays  $125.  These  entries  produce  the  same  results  as 
though  the  entire  capital  had  been  credited  with  interest 
and  the  total  interest,  $10,500,  had  been  divided  in  the 
proportion  last  named. 

If  profits  are  divide^!  in  proportion  to  capital  contrib- 
uted by  the  several  partners,  interest  may  be  reckoned  for 
the  purpose  of  distinguishing  the  business  profits  from 
those  derived  from  invested  capital,  but  the  amounts  cred- 
ited to  each  partner  is  not  thereby  altered.  Hence,  while 
it  may  be  desirable  to  make  allowance  for  interest  even 
though  profits  are  proportionate  to  capital,  this  is  useless 
unless  put  through  the  interest  account  in  full. 

It  is  seen  therefore  that  interest  on  the  partners'  cap- 
ital may  be  estimated  either  on  the  whole  contributed 
capital,  in  which  case  the  entries  must  go  through  the 
Interest  Account,  or  by  figuring  it  merely  on  deficiencies 
and  excesses  (relative  to  the  proportion  in  which  profits 
are  divided).  In  the  former  case  the  entries  must  go 
through  the  Interest  Account;  in  the  latter  the  entries  are 
made  direct  to  the  proprietors'  Capital  accounts  and  do 
not  appear  in  the  Interest  Account.  The  former  method 
not  only  serves  to  adjust  differences-  between  the  partners, 
but  at  the  same  time,  serves  to  distinguish  between  the 
profits  supposedly  arising  from  investment  of  capital  at 
the  normal  rate  of  interest  and  the  profits  of  the  business 
operations.  The  second  method  merely  adjusts  differences 
between  partners. 
23 


324 


MODERN   ACCOUNTING 


Where  the  agreement  does  not  call  for  interest  on  the 
whole  capital  but  only  on  excesses  and  deficits  relative  to 
the  amount  agreed  on  the  treatment  is  quite  similar.  Tims 
if  the  partners  had  agreed  to  contribute  as  follows:  A 
$100,000,  B  $60,000,  and  C  $50,000,  but  in  fact  paid 
$70,000,  $73,000  and  $25,000  respectively,  profits  to  be 
shared  equally,  the  Interest  Account  would  show: 


Dr. 


FORM  130. 

A,  Capital  Account. 


Cr. 


Interest  on  $30,000 $1,500 

Balance 69,200 

$70,700 


Cash $70,000 

§  of  interest  received 700 

$70,700 


Balance $69,200 


Dr. 


B,  Capital  Account. 


Cr 


Balance $74,350 


$74,350 


Cash 

Interest  on  $13,000. . 
J  of  interest  received . 


$73,000 
650 
700 

$74,350 


Balance $74,350 


Dr. 


C,  Capital  Account. 


Cr. 


Interest  on  $25,000 $1 ,250 

Balance 24,450 

$25,700 


Cash $25,000 

J  of  interest  received 700 


$25,700 
Balance $24,450 


Dr. 


Interest  Account. 


Cr. 


To  Bon  $13,000 $650 

Balance  to  partners: 

A $7*00 

B 700 

G 700       2,100 

$2,750 


On  A's  deficit. 
On  C's  deficit. 


$1,500 
1,250 


$2,750 


PAKTKEKSHIP   ACCOUNTS 


325 


Had  profits  been  shared  in  proportion  to  the  agreed 
on  contributions  of  capital  (i.e.,  in  ratio  of  10:6:5  in 
this  example)  the  accounts  would  show: 


Dr. 


FORM  131. 
A,  Capital  Account. 


Cr. 


Interest  on  $30,000  deficit    $1,500 
Balance 69,500 

$71,000 


Cash $70,000 

\%  of  interest  received 1,000 

$71,000 


Balance $69,500 


Dr. 


B,  Capital  Account. 


Cr. 


Balance $74,250 


$74,250 


Cash $73,000 

Interest  on  $13,000  excess         650 
^V  of  interest  received. . . .         600 

$74,250 


Balance $74,250 


Dr. 


C,  Capital  Account. 


Cr. 


Interest  on  $25,000  deficit    $1 ,250 
Balance 24,250 

$25,500 


Cash $25,000 

£t  of  interest  received 500 

$25,500 


Balance $24,250 


Dr. 


Interest  Account. 


Cr. 


To  Bon  $13,000 $650 

Balance  to  partners : 
A,W $1,000 

B,  A- 600 

C,  &. 500     2,100 

$2,750 


On  A's  deficit $1,500 

On  C's  deficit 1,250 


$2,750 


326 


MODERN"  ACCOUNTING 


But  in  the  latter  case  the  adjustment  could  have  been 
more  simply  made  by  entries  made  directly  in  the  Capital 
Accounts,  without  passing  through  the  Interest  Account. 
But  where  this  shorter  method  is  used,  the  amount,  on 
which  interest  is  charged  or  credited  to  each  partner,  again 
is  not  determined  by  comparing  his  contribution  with  the 
amount  which  he  agreed  to  furnish ;  but  the  amount  which 
he  contributes  is  compared  with  the  proportion  of  the  total 
contributed  capital  corresponding  to  his  share  in  the 
profits.  Thus  in  the  above  example  A's  actual  contribu- 
tion of  $70,000  is  compared,  not  with  the  amount  agreed 
on,  namely,  $100,000,  but  with  £f  (the  ratio  in  which  he 
shares  profits)  of  the  total  contributed  capital,  $168,000, 
i.  e.,  with  $80,000,  showing  a  deficit  of  $10,000,  B's  actual 


Dr. 


FORM  132. 
A,  Capital  Account. 


Cr. 


Interest  on  $10,000  deficit       $500 
Balance 69,500 

$70,000 


Cash $70,000 

$70,000 


Balance $69,500 


Dr. 

B,  Capital  Account.                                      Cr. 

Balance  

$74,250 

Cash  $73,000 

$74,250 

Interest  on  $25,000  excess      1  ,250 

$74,250 

Balance  $74,250 

Dr. 


C,  Capital  Account. 


Cr. 


Interest  on  $1 5,000  deficit       $750 
Balance 24,250 

$25,000 


Cash $25,000 


$25,000 
Balance $24,250 


PARTNERSHIP   ACCOUNTS 


327 


contribution  is  compared  with  ^  of  $168,000  or  $48,000, 
showing  an  excess  of  $25,000,  and  C's  with  -^  or  $40,000, 
showing  a  deficit  of  $15,000.  The  accounts  would  there- 
fore appear  as  in  Form  132. 

To  sum  up :  When  interest  is  allowed  on  the  total  cap- 
ital, entries  may  be  through  the  Interest  Account,  or  the 
adjustment  may  be  made  directly  between  the  Capital  Ac- 
counts  by  allowing  interest  on  excesses  and  deficits  relative 
to  the  proportion  of  total  contributed  capital  correspond- 
ing to  the  individual  partner 's  share  of  profits.  But  where 
interest  is  allowed  only  on  excesses  and  deficits,  the  shorter 
method  can  be  used  only  where  profits  and  assumed  capital 
contributions  are  proportionate.  Otherwise  the  adjust- 
ment of  excesses  must  be  made  by  the  longer  form  of  put- 
ting entries  through  the  interest  or  other  similar  account. 

A  third  problem  relates  to  the  final  distribution  of  as- 
sets in  case  of  liquidation.  Here  great  confusion  exists, 
even  in  the  decisions  of  courts.  To  illustrate,  there  may  be 
taken  a  partnership  between  A  and  B  in  which  A  fur- 
nishes $2,000  and  B  $500,  profits  to  be  shared  equally.  But 
losses  having  been  suffered,  the  total  assets  amount  to  only 
$1,000,  the  balance  sheet  showing : 


Dr. 


FORM  133. 

Balance  Sheet. 


Cr. 


Cash $1,000 

Deficit 1,500 

$2,500 


A,  Capital  Account $2,000 

B,  Capital  Account 500 

$2,500 


It  has  been  variously  claimed  that  in  such  a  case  the  avail- 
able cash  is  to  be  divided  either  on  the  basis  of  the  divi- 
sion of  the  profits,  i.  e.,  $500  to  each ;  or  on  the  basis  of  con- 
tributed capital,  i.  e.,  $800  to  A  and  $200  to  B.  Neither  of 
these  is  correct  from  the  accounting  viewpoint.  The  loss 


328 


MODERN   ACCOUNTING 


of  $1,500  by  the  terms  of  the  agreement  being  divisible 
equally,  the  accounts  should  show : 


Dr. 


FORM  134. 
Balance  Sheet. 


Cr. 


Cash $1,000 

B,  deficit 250 

$1,250 


A,  Capital  Account $1,250 


$1,250 


so  that  A  is  entitled  not  only  to  the  cash  but  has  a  valid 
claim  against  B  for  $250.  A  moment's  glance  will  show 
that  in  no  other  way  can  losses  be  shared  equally,  and  this 
is  the  doctrine  of  Nowell  v.  Nowell  (,L.  R.  7  Eq.  538 
(1869)). 

Somewhat  more  complicated,  but  similar  in  principle 
is  a  case  where  three  partners  whose  statement  is : 


Dr. 


FORM  135. 
Balance  Sheet  of  A,  B,  and  C. 


Cr. 


Cash $2,200 

Deficit 4,800 


$7,000 


A,  Capital  Account $2,000 

B,  Capital  Account 500 

C,  Capital  Account. 4,500 

$7,000 


Dividing  the  deficit  gives : 


Dr. 


FORM  136. 
Balance  Sheet. 


Cr. 


Cash $2,200 

B,  deficit 1,100 

$3,300 


A,  Capital  Account $400 

C,  Capital  Account 2,900 

$3,300 


If  now,  B  is  found  to  be  insolvent  and  the  claim  against 
him  worthless,  a  great  variety  of  opinions  are  given  as  to 


PARTNERSHIP   ACCOUNTS 


329 


the  proper  division  of  the  remaining  assets  between  A  and 
C.  Thus  it  has  been  claimed  that  A  is  entitled  to  one  half 
of  the  cash,  or  $1,000,  others  say  to  £§  or  676.92,  and  still 
other  claims,  whose  reasoning  need  not  be  given  here,  but 
which  may  perhaps  be  worked  out  by  the  curious  reader, 
give  him  $1,661.54,  $2,113.04,  and  $266.66. 

To  the  accountant  the  solution  is  simple  and  clear. 
There  being  only  $2,200  cash  with  which  to  pay  the  $3,300 
due  to  A  and  C,  the  two  together  are  to  suffer  a  further 
loss  of  $1,100  which  according  to  the  terms  of  the  agree- 
ment is  to  be  borne  equally.  Hence,  charging  the  worth- 
less claim  against  B  equally  to  A  and  C  gives : 


Dr. 


FORM  137. 
Balance  Sheet. 


Cr. 


Cash $2,200 

A,  deficit 150 

$2,350 


C $2,350 


$2,3.50 


whereby  A,  instead  of  receiving  anywhere  from  $676.92  to 
$2,113.04,  is  compelled  to  pay  C  $150. 

While  the  correctness  of  the  principle  involved  in  this 
solution  is  recognized  by  accountants,  the  courts  have  not 
been  so  uniform.  However,  it  is  most  fully  set  forth,  with 
illustrative  examples  in  the  case  of  Raymond  v.  Putnam 

(44  N.  H.  160  (1862)'),  and  has  been  more  recently  vouched 
for  in  Whitcomb  v.  Converse  (119  Mass.  38  (1875))  and 
confirmed  in  Woelfel  v.  Thompson  (173  Mass.  301  (1899) ). 
Unfortunately  a  recent  English  ease  (Garner  v.  Murray 

[1904]  1  Ch.  57),  relying  pn  the  phraseology  of  the  statute, 
sanctions  another  solution.1 

1  The  decision  in  Garner  v.  Murray  has  been  much  discussed  by 
accountants.  A  series  of  interesting  communications  on  the  subject 
may  be  found  in  the  Accountant  for  1904.  It  is  also  discussed  in 


330  MODERN  ACCOUNTING 

The  foregoing  discussion  shows  the  futility  of  the  ques- 
tion frequently  raised  as  to  the  basis  on  which  assets  are 
to  be  divided,  the  ratio  in  which  losses  are  shared  being 
already  given.  Such  a  question  involves  a  misconception 
or  else  is  purely  gratuitous.  If  all  losses  are  shared  accord- 
ing to  the  agreed  proportion,  the  capital  accounts  of  the 
several  partners  show  the  amounts  which  they  are  sev- 
erally to  receive  or  pay.  Evidently  a  firm  starting  with  an 
equality  of  assets  and  capital  will,  by  the  most  elementary 
principle  of  bookkeeping,  have  assets  still  equaling  the 
balances  of  the  Capital  Accounts  if  all  shrinkages  are  de- 
ducted from  the  original  credits.  One  needs  not  estimate 
proportions,  the  absolute  amounts  must  appear  in  the  Capi- 
tal Accounts  themselves.  To  determine  the  final  distribu- 
tion of  assets  it  is  necessary  only  to  determine  profits  and 
losses,  to  divide  these  in  the  agreed  proportion,  and  to 
discharge  the  remaining  capital  balances,  collecting  from 
the  debtor,  and  paying  to  the  creditor  partners. 

In  one  set  of  circumstances  there  is,  however,  a  problem 
of  division  of  assets  apparently  distinct  from  that  of  appor- 
tionment of  losses.  This  occurs  where  a  liquidation  takes 
place  and  it  is  desired  to  distribute  the  assets  in  install- 
ments as  quickly  as  they  are  realized,  and  hence  before  the 
net  loss  is  ascertained.  The  aim  is  to  distribute  the  assets 
in  such  proportions  that  in  any  contingency  no  one  part- 

Dicksee's  "  Advanced  Accounting,"  2d  ed.,  p.  66.  Dicksee  favors  the 
solution  here  given,  but  in  attempting  to  work  out  a  solution  corre- 
sponding to  the  decision  of  the  court  he  seems  to  have  misunderstood 
the  latter. 

The  court  records  furnish  many  other  interesting  illustrations  of  the 
difficulty  which  the  legal  mind  finds  in  solving  problems  requiring  ac- 
counting knowledge.  Aside  from  mere  arithmetical  errors,  which  are 
surprisingly  common,  many  of  the  decisions  involve  errors  in  principle. 
Cases  in  point  are:  Gunnell  v.  Bird,  10  Wall.  304;  Oakley  v.  Cokalete, 
41  N.  Y.  Supp.  1124;  Schulte  v.  Anderson,  13  Jones  &  Sp.  489;  Butler 
v.  Ballard,  43  N.  Y.  Sup.  Ct.  191.  The  last  named  is  quoted  anrf 
criticised  by  W.  C.  Jaudon  in  Banking  Law  Journal,  XI,  342. 


331 


ner  will  be  paid  more  than  his  share.  This  may  be  illus- 
trated by  taking  the  case  of  a  partnership  in  which  the 
profits  and  losses  are  to  be  divided  as  follows :  50  per  cent, 
to  A,  30  per  cent,  to  B,  and  20  per  cent,  to  C,  the  balance 
sheet  before  liquidation  begins  being: 


Dr. 


FORM  138. 
Balance  Sheet  of  A,  B,  and  C. 


Cr. 


Assets $25,000 

Deficit 5,000 


$30,000 


A,  Capital  Account $10,000 

B,  Capital  Account 10,000 

C,  Capital  Account 10,000 

$30,000 


Oil  the  principle  already  discussed  the  deficit  is  appor- 
tioned among  the  partners,  leaving  the  claims  of  A,  B,  and 
C  at  $7,500,  $8,500,  and  $9,000  respectively.  If  the  assets 
were  all  in  ready  cash  the  problem  of  distribution  would 
be  removed.  But  assuming  that  the  assets  are  only  grad- 
ually sold  and  converted  into  cash,  the  yield  in  successive 
installments  being  $10,000,  $8,000,  and  $6,000,  after  which 
nothing  remains,  there  is  a  real  problem  as  to  the  proper 
distribution  of  each  installment.  When  the  first  installment 
of  $10,000  is  received  how  should  it  be  divided  ?  It  should 
not  be  divided  in  proportion  to  the  original  contributions 
of  capital,  that  is,  in  thirds ;  nor  in  the  same  proportion  as 
profits  were  divisible,  that  is,  in  the  ratio  of  5:3:2;  nor 
in  proportion  to  the  capital  then  standing  on  the  books, 
that  is,  in  the  ratio  of  75 :  85 :  90.  The  correct  method  is 
as  follows:  It  being  impossible  to  know  beforehand  how 
much  the  remaining  assets  will  yield,  it  is  necessary  to 
equalize  the  status  of  the  partners  so  that  if  no  more  cash 
is  received  the  actual  losses  will  be  in  the  predetermined 
ratio.  If  nothing  had  been  realized  the  net  loss  of  each 
of  the  partners  would  have  been  $7,500,  $8,500,  and  $9,000 


332  MODERN  ACCOUNTING 

respectively.  But  if  A  loses  $7,500,  B  should,  by  the  part- 
nership agreement,  lose  only  $4,500  and  C  only  $3,000. 
Before  paying  anything  more  to  A  $4,000  should  therefore 
be  paid  to  B  and  $6,000  to  C.  The  $10,000  cash  should 
accordingly  be  divided  on  this  basis.  The  illustration  is 
here  made  simple  by  assuming  a  first  installment  just  suf- 
ficient to  equalize  the  status  of  the  three  partners  and  by 
omitting  all  consideration  of  expenses  and  interest.  But 
similar  reasoning  would  determine  the  distribution  had 
some  smaller  sum  been  available  for  dividends. 

The  adjustment  between  partners  having  once  been 
made,  all  further  installments  are  to  be  divided  in  propor- 
tion to  the  division  of  losses.  This  is  not  because  the  divi- 
sion of  assets  is  at  all  the  same  as  the  division  of  profits 
or  of  losses,  but  because  this  method  of  treating  all  un- 
realized assets  as  potential  losses  prevents  any  one  of  the 
partners  being  overpaid.  After  the  distribution  of  the 
three  installments  the  accounts  will  appear  as  in  Form 
139.  If  the  assets  fail  to  produce  more  the  losses  are  still 
properly  divided  according  to  the  agreed  ratio.1 

The  discussion  in  the  present  chapter  does  not  profess 
to  treat  any  problems  save  those  which  seem  peculiar  to 
the  status  of  partnership.  "While  in  the  keeping  of  part- 
nership accounts  questions  will  arise  as  to  the  most  con- 
venient method  of  booking  certain  transactions,  these  are 
ordinarily  mere  questions  of  general  bookkeeping  technic 
and  not  peculiar  to  partnership.  Or  problems  may  arise 
such  as  the  amount  of  profits  to  be  divided,  but  these  are 
all  matters  of  accounting  principles  elsewhere  discussed, 
say  under  valuation,  depreciation,  or  profits;  questions  all 

1  The  problems  involving  the  principle  discussed  above  are  given  in 
Dicksee's  "Advanced  Accounting  "  (p.  69)  and  in  Breaker  and  Chap- 
man's "American  Accountants'  Manual."  The  solution  given  in  the 
former  is  correct,  but  in  the  latter,  the  authors,  while  apparently 
recognizing  the  correct  method,  fail  rigorously  to  apply  it  so  that  the 
results  are  in  part  wrong. 


PARTNERSHIP   ACCOUNTS 


333 


Dr. 


FORM  139. 

A,  Capital  Account. 


Cr. 


Deficit $2,500 

Cash  50%  of  2d  install- 
ment   4,000 

Cash  50%  of  3d  install- 
ment   3,000 

Balance 500 

$10,000 


Original  capital $10,000 


$10,000 
Balance $500 


Dr. 


B,  Capital  Account. 


Cr. 


Deficit $1,500 

Cash  40%  1st  installment .  4,000 

Cash  30%  2d  installment .  2,400 

Cash  30%  3d  installment .  1,800 

Balance : 300 

$10,000 


Original  capital $10,000 


Balance. 


Dr. 


C,  Capital  Account. 


$10,000 
$300 

Cr. 


Deficit $1,000 

Cash  60%  1st  installment.  6,000 

Cash  20%  2d  installment.  1,600 

Cash  20%  3d  installment.  1,200 

Balance 200 

$10,000 


Original  capital $10,000 


Balance. 


$10,000 
~$200 


of  which  refer  to  corporation  and  individual  accounts  as 
well  as  to  those  of  partnership.  The  partnership  problems, 
as  such,  are  generally  involved  in  the  correct  interpreta- 
tion of  the  partnership  agreements,  perhaps  ambiguously 
drawn  up  or  even  resting  on  a  vague  oral  agreement,  and 
have  to  do  primarily  with  the  essential  relationship  of  the 
individual  partners,  the  terms  on  which  they  unite,  the 


334  MODERN  ACCOUNTING 

division  of  profits,  the  adjustment  of  unpaid  capital  con- 
tributions through  allowances  for  interest,  and  the  final 
distribution  of  assets,  all  of  which  transactions  must  con- 
form to  the  rules  of  the  partnership  agreement. 


BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  XVII 

CHILD,  P.     Partnership  Accounts.    Third  edition.     London,  1904. 

DICKSEE,  L.  R.  Advanced  Accounting.  Chapter  XIII.  Third 
edition.  London,  1908. 

LINDLEY,  N.  A  Treatise  on  the  Law  of  Partnership.  II,  pp. 
396-403.  American  edition. '  Jersey  City,  1888. 

LISLE,  G.  Interest  on  Capital  in  Partnership.  Article  in  En- 
cyclopedia of  Accounting,  III,  pp.  432-438. 


CHAPTER   XVIII 

THE  STATEMENT  OF  AFFAIRS  AND  DEFICIENCY  ACCOUNT 

THESE  statements,  while  somewhat  outside  of  the  regu- 
lar scheme  of  accounts,  are  sufficiently  important  to  de- 
serve some  notice.  The  Statement  of  Affairs  is  a  statement 
drawn  up  when  a  concern  becomes  insolvent,  and  designed 
to  indicate  to  creditors  the  probable  amount  which  will  be 
realized  in  liquidation.  The  Deficiency  Account  is  a  sup- 
plement to  the  Statement  of  Affairs  and  serves  to  explain 
how  the  deficiency  shown  by  the  Statement  of  Affairs  has 
been  caused. 

The  use  of  these  forms  is  of  English  origin  and  depends 
on  the  provisions  of  the  Companies  Acts  which  prescribes 
the  form  in  which  they  shall  be  made  out.  In  the  United 
States  the  laws  are  less  exact  regarding  bookkeeping  forms, 
and  the  statements  submitted  to  the  courts  are  generally 
not  in  strict  accounting  form.  But  despite  the  absence  of 
legal  authorization,  the  advantage  which  results  from  a 
clear  and  formal  presentation  of  the  status  of  the  involved 
concern  is  so  great  that  American  accountants  are  also 
frequently  making  use  of  the  Statement  of  Affairs  and 
Deficiency  Account. 

The  use  of  these  forms  may  be  illustrated  by  presenting 
an  example  applying  to  a  typical  problem  but  one  which 
contains  only  a  few  items  and  is  free  from  complications. 

The  firm  of  A  &  B  finding  itself  financially  embar- 
rassed is  forced  to  go  into  liquidation  November  30,  1908. 
A  statement  drawn  from  the  books  at  that  date  shows  the 
Trial  Balance  exhibited  on  the  following  page. 

335 


336 


MODERN   ACCOUNTING 


Dr. 


Trial  Balance. 


Cr. 


Real  estate $70,000 

Investments 140,000 

Merchandise 100,000 

Bills  Receivable 2 1 ,250 

Accounts  Receivable. . . .  14,250 

Drawings  A 12,000 

Drawings  B 10,000 

Bad  debts  charged  off.. . .  1 5,000 

Expenses 10,670 

Cash 1,330 

$394,500 


A,  Capital $35,000 

B,  Capital 30,000 

Bills  Payable 204,500 

Accounts  Payable 125,000 


$394,500 


A  further  examination  of  the  condition  of  the  firm  dis- 
closes the  following  facts: 

Of  the  Investments,  all  of  which  are  good,  $100,000  are 
pledged  to  secure  a  note  of  $85,000  and  $15,000  are  pledged 
with  the  holder  of  a  note  of  $20,000. 

Of  the  Accounts  Receivable  $5,000  are  recognized  as 
bad,  $3,000  are  doubtful  with  an  estimated  value  of  $1,000, 
the  remainder  are  good. 

The  Bills  Receivable  are  estimated  as  worth  $15,000. 

The  Merchandise  is  estimated  as  worth  $60,000,  and 
the  Real  Estate  as  worth  $50,000. 

In  addition  to  the  liabilities  shown  on  the  books,  $2,500 
is  due  for  wages,  $1,000  for  salaries,  and  $250  for  taxes, 
all  of  which  are  preferential  claims  against  the  assets. 

With  these  facts  and  estimates  the  Statement  of  Affairs 
and  Deficiency  Account  would  be  as  follows: 


*t3  O 

V    N 

1 

S 

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11 

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Creditors  p 
Less  sec 

Creditors  f 
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T>  r  i  . 

§     1 

-        -o 
u           <u 

3          Q 
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837 


MODEKN   ACCOUNTING 


Dr. 


FORM  141. 

Deficiency  Account. 


Cr. 


To  Capital  on  Jan.  1, 190-  $65,000 
"     Deficiency     as     per 

statement  of  affairs.    59,670 


$124,670 


By  sundry  trade  losses. . . .  $29,420 
"  Shrinkage   as    per 
statement  of  affairs, 
viz.: 

Book  Accounts .  $7,000 
Bills  Receivable .    6,250 

Merchandise 40,000 

Real  Estate 20,000   73,250 

"  Drawings  of  partners.. . .    22,000 
$124,670 


Considerable  variation  is,  however,  found  in  the  ar- 
rangement of  such  statements.  In  the  form  given  above 
it  is  noticed  that  the  Liabilities  are  given  on  the  left  hand, 
just  as  they  appear  on  that  side  in  English  Balance  Sheets. 
By  some  accountants  this  order  is  reversed.  Similarly  there 
is  a  disagreement  in  practice  regarding  the  arrangement 
of  the  sides  of  the  Deficiency  Account,  some  placing  the 
Deficiency  and  Capital  items  on  the  Debit  side,  and  .the 
items  showing  how  the  losses  occurred  on  the  Credit  side  of 
the  account,  as  is  done  above,  while  others  reverse  this 
order.  There  are,  accordingly,  four  different  combinations, 
all  of  which  have  the  support  of  authorities  of  repute. 
These  may  be  scheduled  as  follows : 

Variations  in  Arrangement  of  Statement  of  Affairs  and  Deficiency  Account. 


Statement  of  Affairs. 

Deficiency  Account. 

la. 
Ib. 

Ila. 
lib. 

Left  Column. 

Right  Column. 

Left  Column. 

Right  Column. 

Liabilities. 
a 

Assets. 
« 

Assets. 

« 

Liabilities. 
n 

Capital  and  Deficiency. 
Shrinkages,  etc. 
Capital  and  Deficiency. 
Shrinkages,  etc. 

Shrinkages,  etc. 
j  Capital  and  ) 
(  Deficiency.    ) 
Shrinkages,  etc. 
\  Capital  and  ) 
"(  Deficiency,  f 

STATEMENT    OF   AFFAIES  339 

Of  these  various  forms  la  corresponds  to  the  schedules 
of  the  English  Companies  Acts,  is  most  generally  used  in 
England,  and  in  this  country  is  used,  for  instance,  in 
Broaker  and  Chapman's  "  American  Accountants'  Man- 
ual," and  in  W.  H.  Dennis's  "  Practical  Accounting." 
The  second  arrangement  (Ib)  is  the  one  approved  by  Lisle. 
The  third  (Ila)  is  favored  by  F.  S.  Tipson  in  his  "  Theory 
of  Accounting  "  and  in  the  model  form  given  by  Leo 
Greendlinger  in  the  Journal  of  Accountancy.  The  last 
form  bears  the  approval  of  A.  G.  Platt  as  shown  in  the 
appendix  to  Kahili's  "  Corporation  Accounting." 

Some  of  the  authors  mentioned  above  have  argued  at 
some  length  in  favor  of  one  or  the  other  arrangement. 
Some  ingenuity  has  been  exhibited  in  showing  that  the 
arrangement,  Liabilities— Assets,  has  some  particular  logi- 
cal justification  when  used  in  the  Statement  of  Affairs. 
But  historically  it  doubtless  arose  as  the  result  of  that 
arrangement  in  the  Balance  Sheet,  which  has  not  been  fol- 
lowed elsewhere  than  in  England.  It  may  furthermore  be 
noted  that  in  forms  la  and  lib  the  deficiency  shown  in  the 
Statement  of  Affairs  is  carried  to  the  opposite  side  of  the 
"Deficiency  Account,  just  as  a  balance  of  any  account  is  thus 
transferred  to  another  account.  But  in  forms  Ib  and  Ila 
the  deficiency  item  appears  on  the  same  side  of  the  two 
accounts.  Probably  the  preponderance  of  custom  is  in 
favor  of  the  form  given  above  (la),  although  in  view  of 
the  divergences  noted  it  cannot  be  said  that  this  form  is 
at  all  binding.  One  may  accept  the  prevalent  custom  with- 
out agreeing  with  the  arguments  given  to  show  that  the 
arrangement  is  logical  as  well  as  customary. 

The  purpose  of  these  statements  being  to  present  to  the 
general  creditors  a  succinct  view  of  the  status  of  the  con- 
cern, the  best  arrangement  is  to  eliminate  all  secured 
claims  and  the  property  by  which  they  are  protected  from 
the  figures  showing  the  net  assets  and  the  ranking  lia- 

93 


340  MODERN  ACCOUNTING 

bilities.  A  comparison  of  the  resulting  totals  gives  the  per« 
centage  on  general  claims  which  may  be  expected,  without 
allowing  for  expenses  of  liquidation.  "Where  a  claim  is 
secured  by  some  specific  collateral  the  two  items  should 
be  canceled  against  each  other  as  is  shown  in  the  treat- 
ment of  the  ' '  Creditors  fully  secured  ' '  above.  But  where 
the  claim  is  not  secured  by  a  specific  security  it  is  deducted, 
from  the  total  assets,  as  in  case  of  the  "Wages  and  Taxes 
in  the  illustration  given.  Some  accountants  object  to  thus 
subtracting  claims  not  secured  by  specific  collateral,  but 
the  general  practice  favors  so  doing. 

In  the  Deficiency  Account  given  above  the  business  had 
been  run  at  a  loss,  as  shown  by  the  item  of  Sundry  Trade 
Losses.  It  is  desirable  to  make  the  showing  in  the  de» 
ficiency  account  as  complete  as  possible,  and  therefore  it 
may  cover  the  operations  of  several  years,  showing  on  one 
side  the  original  capital  and  the  profits  made  in  certain 
years,  on  the  other  side  of  the  account  the  net  losses  of 
other  years,  separately  displayed.  If  the  concern  is  a 
corporation,  dividends  paid  should  be  disclosed  just  as 
withdrawals  by  the  partners  are  shown  in  the  present 
illustration. 


BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  XVIII 

BROAKER,  F.  and  CHAPMAN,  R.  M.  The  American  Accountants' 
Manual.  I,  pp.  109-130.  New  York,  1897. 

DICKSEE,  L.  R.  Advanced  Accounting.  Chapters  XI V-XV.  Third 
edition.  London,  1908. 

GOTTSBERGER,  F.  Accountant's  Guide  for  Executors,  Administra- 
tors, Assignees,  Receivers,  and  Trustees.  New  York,  1902. 


CHAPTER   XIX 

TECHNICAL   IMPROVEMENTS   IN   ACCOUNTING   PRACTICE 

WHILE  bookkeeping  has  preserved  unaltered  the  essen- 
tial principles  involved  in  Paciolo's  treatise,  yet  the  prac- 
tice of  the  art  has  not  been  stationary  during  the  past  four 
centuries.  Two  lines  of  development  may  be  mentioned. 
One  has  been  in  the  direction  of  technical  devices,  of  one 
kind  and  another,  designed  to  lessen  the  routine  drudgery 
of  the  bookkeeper — labor-saving  devices  which  either  elimi- 
nate part  of  the  work  not  essential  to  securing  the  neces- 
sary results,  or  assist  the  accountant  in  performing  the  un- 
avoidable operations.  The  second  line  of  development  is 
one  in  which  the  operations  of  bookkeeping  and  the  results 
obtained  are  made  to  correspond  with  the  changing  eco- 
nomic conditions  and  the  resulting  modifications  of  busi- 
ness activities. 

The  more  technical  improvements  which  have  taken 
place  may  be  grouped  as  affecting 

1.  The  relation  between  the  chronological  and  classified 
records  of  business  transactions. 

2.  The  form  and  arrangement  of  the  ledger. 

3.  The  performance  of  the  necessary  mathematical  cal- 
culations by  substituting  machine  labor  in  such  operations. 

1.  It  has  been  seen  that  the  significant  feature  of  double 
entry  bookkeeping  is  a  classified  outline  of  all  business 
operations,  which  is  kept  in  what  is  called  a  ledger.  The 
ledger  is  thus  the  essential  book,  at  least  so  far  as  account- 
ing theory  is  concerned.  Indeed,  it  has  occasionally  been 

341 


342  MODEKN  ACCOUNTING 

the  only  book  kept,  as  for  instance  by  the  earlier  Venetian 
accountants,  or  as  advocated— as  though  it  were  a  distinct 
invention  of  his  own— by  Lizet  in  1660;  yet  it  has  been 
well-nigh  universally  recognized  that  it  is  practically  neces- 
sary to  have  a  chronological  as  well  as  a  classified  record 
of  business  transactions. 

But  the  form  in  which  this  chronological  record  is  kept, 
and  the  method  by  which  the  record  is  transcribed  from 
the  original  record  into  the  ledger  have  been  greatly  modi- 
fied,' always  with  a  view  to  eliminate  needless  repetition 
and  to  save  unnecessary  labor.  Paciolo  considered  it  de- 
sirable to  have  a  threefold  series  of  records.  The  first  called 
Memorial,  a  term  still  used  in  Germany,  contained  a  mere 
description  of  the  transaction,  generally  expressed  in  un- 
technical  language.  The  second,  or  Journal,  repeated  the 
record  but  expressed  it  in  technical  terms,  with  values  re- 
duced to  the  current  money  of  account,  and  with  a  clear 
indication  of  which  ledger  account  was  to  be  debited  and 
which  was  to  be  credited.  From  the  Journal  the  proper 
postings  were  made  into  the  Ledger. 

This  complicated  process  was  perhaps  originally  neces- 
sary. As  Row-Fogo  has  pointed  out,  in  the  beginnings  of 
modern  commerce,  when  there  was  no  uniform  coinage,  it 
was  frequently  a  difficult  task  to  translate  the  transaction 
into  terms  suitable  for  posting  into  the  Ledger.  Yet  it  was 
desirable  to  make  the  first  record  at  once,  leaving  the  pro- 
prietor to  determine  later  the  form  in  which  it  should  ulti- 
mately appear  in  the  Ledger.  This  was  perhaps  all  the 
more  necessary  as  it  was  customary  to  use  the  books  of 
account  not  merely  as  a  record  of  the  transaction  but  as 
well  as  legal  evidence  of  the  contract,  with  the  signatures 
of  the  verifying  witnesses.  Such  an  entry  may  be  shown 
by  quoting  from  an  account  book  kept  more  than  five  hun- 
dred years  ago  by  a  merchant  of  Hamburg : 

' '  Bertold  Scroder  and  Herr  Johann,  his  son,  the  Pres- 


TECHNICAL  IMPEOVEMENTS  343 

byter,  are  together  indebted  for  24  marks  for  two  pieces  of 
Oldenard  cloth  viz:  1  red  and  1  blue  which  they  bought 
on  the  day  after  the  feast  of  St.  Peters  Chains,  to  be  paid 
at  the  beginning  of  Fast  time.  In  presence  of  Herren 
Johann  Stuveke  and  Luke  and  Albert  Albecke." 

But  the  elaborateness  of  entry  became  needless  and  un- 
desirable as  commerce  became  better  systematized.  Evi- 
dences of  contract  were  more  conveniently  kept  elsewhere, 
instead  of  crowding  them  into  the  record  of  transactions; 
the  use  of  uniform  currency  made  a  definite  entry  no  lon- 
ger difficult;  and  the  conventional  threefold  series  of  Me- 
morial, Journal,  and  Ledger,  if  not  altogether  abandoned, 
is  at  least  obsolescent. 

Especially  in  American  practice  has  there  been  a  tend- 
ency to  simplify  and  abridge.  The  Memorial,  called  in 
English  the  Day  Book,  a  most  inappropriate  term  to  be 
used  in  contradistinction  to  Journal,  both  having  the  same 
root  meaning,  has  largely  disappeared  as  a  separate  book. 
Where  detailed  description  of  the  transaction  is  still  re- 
quired it  is  written  directly  in  the  Journal  itself.  But  not 
content  with  the  elimination  of  the  Memorial  or  Day  Book, 
modern  bookkeeping  has  gone  farther  and  has  to  a  con- 
siderable extent  dispensed  with  the  Journal,  at  least  in  the 
sense  of  the  formal  and  somewhat  stately  record  in  which 
the  bookkeepers  of  the  last  generation  thought  necessary  to 
make  the  entry  before  it  could  appear  in  the  Ledger,  and 
from  which  each  item  was  separately  transcribed. 

This  has  been  brought  about  by  using  a  columnar  rec- 
ord, in  which  items  of  a  similar  nature,  as,  for  instance, 
Cash,  Discount,  and  Merchandise,  are  placed  in  separate 
columns  and  the  footings  of  these  columns,  not  the  indi- 
vidual items,  are  posted  into  the  Ledger. 

This  device,  which  appears  in  myriad  forms,  may  be 
illustrated  by  a  Columnar  Journal-Cash  Book,  as  shown 
in  Form  142. 


344 


MODEKN  ACCOUNTING 


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TECHNICAL   IMPROVEMENTS  345 

Here  only  the  footings  of  the  several  columns,  Accounts 
Receivable,  Accounts  Payable,  etc.,  are  posted  into  the 
Ledger.  Items  occurring  too  infrequently  to  need  a  spe- 
cial column  can,  however,  be  entered  in  the  last  column, 
with  the  name  of  the  account  to  which  the  special  entry  is 
to  be  posted. 

Carried  to  a  logical  extreme  the  columnar  system  be- 
comes at  once  Journal  and  Ledger,  the  column  for  the 
descriptive  text  furnishing  the  chronological  record,  while 
the  distribution  of  amounts  into  various  columns — a  sepa- 
rate column  being  provided  for  each  account— serves  for 
the  classified  record  or  Ledger.  This  is  what  was  done  in 
Form  1  on  page  5.  In  that  example  the  perfect  com- 
bination of  Journal  and  Ledger  was  easily  accomplished 
because  the  scheme  of  accounts  consisted  of  only  three  ac- 
counts. With  a  large  number  of  accounts  it  is  easily  seen 
that  such  a  system  is  impossible.  Even  where  there  is  no 
attempt  to  dispense  with  the  Ledger  and  the  columnar 
Journal  is  used  only  as  a  means  of  obtaining  footings  for 
posting,  the  increase  in  the  number  of  such  columns  soon 
becomes  objectionable.  The  book  itself  becomes  unwieldy, 
it  is  uneconomical  of  paper,  and  the  danger  of  making  the 
entry  in  the  wrong  column  becomes  increasingly  great. 
While  the  columnar  system  thus  has  clear  limitations,  its 
acceptance  has  become  very  widespread,  especially  in  the 
United  States.  It  is  less  common  in  Europe,  where  the 
term  American  Bookkeeping  is  applied  to  a  system  using 
books  so  ruled. 

Parallel  with  the  abolition  of  the  unnecessary  duplica- 
tion of  Memorial  and  Journal,  there  has  been  an  increase 
in  the  number  of  books  from  which  postings  are  made  into 
the  ledger.  In  Paciolo's  scheme  all  entries  came  into  the 
Ledger  through  the  Journal,  in  modern  accounting  there 
may  be  a  dozen  books  from  which  postings,  generally  of 
footings,  are  made  into  the  Ledger.  This  is  rendered  neces- 


346  MODERN  ACCOUNTING 

sary  by  the  increase  in  the  amount  of  business  transacted, 
which  makes  it  impossible  for  one  person  to  make  all  the 
entries  of  current  transactions.  By  dividing  the  books  of 
original  entry,  so  that  transactions  of  different  classes  are 
made  in  separate  books,  an  indefinite  number  of  clerks  can 
be  simultaneously  engaged  in  making  entries,  while  the 
posting  into  the  Ledger  can  be  done  later,  by  totals.  The 
first  division  of  this  kind  to  be  made  was  the  separation  of 
all  transactions  in  which  a  cash  payment  is  involved.  The 
separate  Cash  Book  was  not  known  to  Paciolo  and  did  not 
appear  until  about  the  middle  of  the  sixteenth  century. 
At  present  not  only  cash,  but  many  other  transactions,  pur- 
chases, sales,  discounts,  loans,  etc.,  are  entered  indepen- 
dently in  separate  books  and  posted  thence  into  the  Ledger, 
generally  without  passing  at  all  through  the  Journal,  al- 
though by  some  an  entry  of  the  totals  is  passed  through 
that  book. 

In  these  coordinate  books  of  original  entry,  as  well  as 
in  the  Journal,  the  principle  of  columnar  ruling  is  applied. 
It  is  interesting  to  note  that  this  device  was  presented  in 
the  first  American  text-book  on  bookkeeping  published  by 
William  Mitchell  in  1796.  In  this  valuable  but  little- 
known  work  each  side  of  the  Cash  Book  is  provided  with 
columns  for  Merchandise,  Bills  Receivable  (or  Payable), 
and  Sundries. 

It  is  thus  seen  that  there  has  been  a  steady  line  of  de- 
velopment in  bookkeeping  technic  in  connection  with  the 
relation  between  the  chronological  and  the  classified  rec- 
ords, whereby  the  Ledger  has  been  brought  closer  to  the 
original  entries,  duplications  have  been  avoided,  totals  have 
been  entered  instead  of  needlessly  minute  details,-  and 
facilities  have  been  created  for  attending  to  a  greater 
amount  of  business  than  could  have  been  accomplished  by 
the  older  forms.  But  in  all  this  nothing  has  been  done  at 
all  opposed  to  the  principles  of  double  entry  bookkeeping, 


TECHNICAL  IMPROVEMENTS  347 

and  everywhere  the  equation  between  Goods  and  Proprie- 
torship is  maintained  as  carefully  as  ever. 

2.  The  second  line  of  improvements  has  been  in  the 
form  and  arrangement  of  the  Ledger  itself.  In  general  the 
traditional  ruling  of  the  Ledger  has  been  preserved,  and 
there  are  still  two  columns  for  the  Debit  and  Credit  items 
respectively.  Some  little  variation  exists  in  the  position 
of  these  two  columns  relative  to  each  other  and  to  the  col- 
umn for  descriptive  text,  and  at  times  a  third  column  is 
added  to  contain  the  balance.  This  latter  device  means 
some  additional  writing,  but  it  has  the  advantage  of  mak- 
ing immediately  available  the  desired  information  concern- 
ing the  state  of  the  account.  It  is  especially  valuable  in 
connection  with  personal  accounts,  particularly  those  kept 
by  a  bank  with  its  customers,  where  immediate  information 
is  essential.  Such  rulings  have  a  further  advantage  in 
doing  away  with  some  of  the  rather  cumbersome  forms  of 
ruling  off  and  balancing  an  account,  the  saving  in  time 
and  space  in  this  regard  offsetting  to  some  extent  the  ad- 
ditional labor  of  indicating  the  new  balance  after  each 
transaction. 

There  is  also  a  tendency  to  eliminate  unnecessary  detail 
from  the  Ledger  entries,  it  being  more  economical  to  make 
an  occasional  reference  to  some  other  record  than  to  tran- 
scribe all  the  details,  most  of  which  serve  no  purpose,  in 
the  Ledger.  The  regulation  on  which  the  older  writers 
insisted  that  each  Ledger  entry  should  give  the  name  of 
the  other  account — religiously  preceded  by  the  formula 
"  To  "  or  "  By  " — in  which  the  counter  entry  appeared, 
became  impossible  so  far  as  totals  only  were  posted.  It  is 
now  recognized  as  altogether  needless.  The  custom  was 
doubtless  once  useful.  The  older  bookkeeping  technic 
verified  the  accuracy  of  the  Ledger,  not  by  taking  a  trial 
balance  but  by  checking  each  Debit  against  its  correspond- 
ing Credit.  When  this  was  done  it  was  of  great  assistance 


348  MODEEN  ACCOUNTING 

to  have  easy  reference  from  one  account  to  the  other,  and 
this  was  conveniently  given  by  including  in  each  Ledger 
entry  both  the  name  and  the  folio  number  of  the  account 
in  which  the  corresponding  entry  appeared.  Bookkeepers 
long  since  found  it  was  more  useful  to  refer  to  the  Journal 
page  containing  the  original  entry  than  to  the  page  con- 
taining the  balancing  Ledger  entry.  But  the  entry  of  the 
name  of  the  Ledger  account  long  persisted,  and  is  even 
now  inculcated  in  some  text-books.  The  absurdity  of  cling- 
ing to  this  convention  is  greatest  when  the  corresponding 
entry  is  not  found  in  a  single  account  but  in  several,  when 
convention  demanded  that  the  Ledger  should  bear  the 
meaningless  reference  to  "  Sundries."  But  while  refer- 
ence to  the  corresponding  account  is  still  general  in  Con- 
tinental practice,  and  is  doubtless  frequently  found  even 
in  this  country,  it  is  no  longer  considered  necessary  by 
American  accountants.  In  this  respect,  as  in  the  avoidance 
of  the  needless  labor  of  actually  closing  out  all  ledger 
accounts  into  a  Balance  Account,  American  practice  shows 
good  sense  in  lessening  the  drudgery  of  bookkeeping  with- 
out making  its  record  of  business  transactions  less  valuable 
to  the  proprietor. 

A  more  important  improvement  in  the  form  of  the 
Ledger  has  been  the  substitution  of  cards  or  loose  leaves 
in  the  place  of  a  bound  book.  The  advantages  of  this  are : 

The  elimination  of  dead  accounts. 

The  ease  of  reference,  the  accounts  being  self -indexing. 

The  nice  adjustment  to  accounts  of  varying  lengths, 
without  overcrowding  or  wasting  of  blank  pages. 

The  ease  of  expansion  with  a  growing  business. 

The  facility  with  which  the  accounts  may  be  divided  up 
so  that  many  clerks  can  work  simultaneously. 

Unfortunately  some  prejudice  has  existed  against  the 
innovation  on  the  ground  that  it  makes  fraud  more  easy. 
Indeed,  the  careful  prescription  of  some  laws,  such  as  the 


TECHNICAL  IMPEOVEMENTS  343 

Code  de  Commerce  of  France,  to  the  effect  that  legal  valid- 
ity can  attach  only  to  accounts  kept  in  bound  books  with 
serially  numbered  pages  certified  by  a  public  official,  have 
been  a  positive  bar  to  the  introduction  of  card  ledgers, 
which  elsewhere  have  been  less  absolutely  opposed  by  con- 
servatism and  prejudice. 

"While  the  advocates,  and  especially  the  manufacturers 
of  loose-leaf  systems,  vehemently  deny  that  a  bound  ledger 
is  any  more  secure,  their  claims  seem  somewhat  exagger- 
ated. It  is  true  that  the  Ledger  at  best  is  not  the  authori- 
tative record,  yet  the  falsification  of  the  Ledger  is  not  an 
unusual  method  of  concealing  fraud.  Even  the  keeping  of 
Ledgers,  duplicate  except  in  some  doctored  accounts,  has 
been  resorted  to  by  those  wishing  to  hide  their  frauds.  Cer- 
tainly such  manipulation  can  be  more  easily  accomplished 
where  each  account  is  on  a  separate  sheet  or  card.  But 
on  the  other  hand  the  same  precautions  which  should  be 
observed  to  prevent  fraudulent  manipulation  of  bound 
books  would  also  prevent  fraud  in  handling  a  loose-leaf 
system.  In  either  case  there  is  no  security  without  a  care- 
ful system  of  auditing,  and  where  this  is  provided  frauds 
will  be  prevented  because  of  the  certainty  that  they  will 
be  discovered.  Certainly  the  use  of  Card  Ledgers  has  made 
great  advances  since  they  were  first  introduced  in  1889  by 
Mr.  J.  A.  Langstroth,  the  accomplished  accountant  of  the 
San  Francisco  Savings  Union.  The  advantages  far  out- 
weigh any  possible  objections  to  the  system. 

There  has  been  considerable  controversy  as  to  the  rela- 
tive merits  of  cards  and  loose  leaves  temporarily  bound  in 
a  holder.  Universal  preference  should  be  given  neither  to 
one  nor  the  other.  Where  there  are  a  vast  number  of  ac- 
counts with  infrequent  entries  in  each,  as  for  instance  in  a 
great  savings  bank,  separate  cards  seem  to  have  the  advan- 
tage. In  other  cases  the  Loose-Leaf  Ledger  is  more  easy 
to  handle,  less  time  being  consumed  in  turning  pages  tha» 


350  MODEKN   ACCOUNTING 

in  taking  out  and  returning  the  card.  Thus  a  savings  bank 
may  wisely  keep  its  depositors'  accounts  on  cards  while  its 
General  Ledger  accounts  are  kept  in  a  Loose-Leaf  Ledger. 
The  relative  merits  of  competing  devices  for  holding  the 
loose  leaves  need  not  be  discussed  here.  The  interested 
reader  can  easily  obtain  unlimited  advertising  matter  on 
the  subject. 

The  use  of  cards  has  been  of  great  service  in  other  lines 
of  accounting  than  as  a  ledger.  Particularly  true  is  this  in 
keeping  track  of  maturing  notes,  interest  payments,  insur- 
ance, contracts  on  hand,  unfilled  orders,  etc.  They  serve 
also  to  keep  a  continuous  record  or  inventory  of  merchan- 
dise or  material  on  hand,  each  class  of  article  being  listed 
on  a  separate  card.  This  furnishes  a  record  of  quantities 
of  stock,  parallel  with  the  ledger  accounts  showing  values, 
and  constitutes  a  most  valuable  check  on  the  accuracy  of 
the  inventory,  and  on  the  pilfering  tendency  of  employees. 
For  use  in  such  subsidiary  records,  outside  of  the  account- 
ing system  in  the  strict  sense,  cards  have  proved  indis- 
pensable. 

3.  So  much  of  the  labor  of  accounting  consists  in  tha 
performance  of  arithmetical  calculations  that  the  intro- 
duction of  mechanical  devices  for  doing  this  work  is  one 
of  the  marked  improvements  in  bookkeeping  technic.  The 
more  important  instruments  of  this  kind  fall  into  three 
groups:  (1)  adding  machines,  (2)  "  calculating  "  ma- 
chines, designed  primarily  for  multiplying  and  dividing, 
and  (3)  the  mechanical  tabulator. 

Foremost  among  these  are  the  mechanical  devices  for 
adding.  Of  these  three  groups  may  be  mentioned:  (1) 
Those  in  which  the  addition  is  performed  by  the  operator 
moving  a  part  of  the  instrument  for  each  digit  to  be  added, 
the  distance  through  which  the  moving  part  passes  corre- 
sponding to  the  value  of  the  digit;  (2)  those  in  which  the 
addition  is  p'erformed  by  pressing  a  key  indicating  the  de- 


TECHNICAL  IMPEOVEMENTS  351 

sired  digit;  and  (3)  machines  similarly  operated  by  keys 
but  listing  the  items  at  the  same  time  that  they  are  added. 

The  first  class  of  instruments  have  considerable  vogue, 
due  to  their  portability  and  cheapness.  To  accomplish  the 
result  various  mechanical  devices  are  used,  such  as  the  rota- 
tion of  wheels,  the  revolving  of  endless  chains  bearing  num- 
bered links,  and  the  sliding  of  bars.  In  these  instruments 
the  carrying  of  tens  to  the  next  higher  order  of  digits  is 
automatically  performed.  Many  such  adding  machines  are 
in  the  market,  costing  from  one  to  twenty-five  dollars,  each 
of  which  has  its  own  advocates.  But  all  of  these  are  rela- 
tively inefficient  as  compared  with  key-operated  machines. 

In  the  key-adding  machines  the  pressing  of  a  separate 
key  bearing  the  appropriate  digit  serves  to  make  the  proper 
addition,  with,  of  course,  great  increase  in  both  speed  of 
operation  and  price  of  machine  as  compared  with  the  sim- 
pler type  of  adding  machine.  The  use  of  such  key  machines 
is  rapidly  increasing.  In  some  large  establishments  special 
operators  are  provided  whose  duty  it  is  to  go  from  desk 
to  desk  as  occasion  requires,  and  perform  the  additions 
demanded  in  the  several  departments.  While  the  speed  of 
adding  figures  already  listed  in  a  column  may  not  be  much 
greater  when  performed  by  an  operator  on  an  adding  ma- 
chine than  when  done  by  a  highly  skilled  bookkeeper,  the 
cost  of  having  the  work  done  is  much  less  because  of  the 
lower  grade  labor  that  can  operate  the  machine. 

The  listing  machine  is  arranged  on  practically  the  same 
line  as  the  nonlisting  key  machine,  but  is  accompanied 
with  a  device  for  printing  the  item  at  the  same  time  that 
it  is  added.  Many  machines  of  this  type,  differing  in  detail 
but  very  similar  in  form  and  operation,  are  on  the  market. 

Considerable  rivalry  exists  between  the  advocates  of 
listing  and  nonlisting  adding  machines.  As  a  matter  of 
fact  they  are  not  truly  rivals,  each  being  appropriate  for 
its  particular  service.  The  nonlisting  machine  performs 


352  MODERN  ACCOUNTING 

the  adding  operations  much  more  rapidly  than  can  be  done 
on  the  listing  machine.  Where  the  figures  to  be  added  are 
already  listed  it  is,  therefore,  best  adapted.  The  only  ob- 
jection to  be  made  is  the  supposedly  greater  ease  in  detect- 
ing errors  where  a  listing  machine  is  used,  as  the  items  can 
be  checked  off  from  the  list.  But  with  a  little  practice  mis- 
takes in  either  type  of  machine  are  infrequently  made,  and 
it  is  but  little  slower  to  verify  additions  by  repeating  the  op- 
eration on  a  nonlisting  machine  than  it  is  to  check  off  the 
printed  list  against  the  original  items.  But  where  a  list 
of  items  needs  to  be  made,  it  is  evident  that  the  listing 
machine  has  no  fear  of  rivalry  from  the  nonlisting  machine. 
The  nonlisting  machine  has,  however,  an  advantage  for 
certain  kinds  of  work  in  that  it  lends  itself  readily  to  sim- 
ple operations  of  multiplication,  and  less  readily  to  divi- 
sion, operations  which  are  similarly  performed  on  a  listing 
machine  but  with  a  relative  disadvantage  in  speed  greater 
than  that  in  adding. 

The  second  type  of  mechanical  aids  is  the  calculating 
machine  or,  more  concretely,  a  device  for  performing  mul- 
tiplication and  division.  Earliest  of  these  is  the  slide  rule, 
a  device  long  since  introduced  into  engineering  but  rather 
slowly  adopted  by  accountants.  The  slide  rule,  in  its  vari- 
ous forms,  whether  a  simple  rule,  or  in  the  circular,  spiral, 
or  cylindrical  forms  is  a  logarithmic  scale,  that  is,  a  scale  so 
ruled  that  addition  is  substituted  for  multiplication.  Thus, 
for  instance,  on  a  given  scale  3  is  indicated  at  a  point  one 
inch  from  the  left-hand  end  of  the  rule.  But  the  value  in- 
dicated at  a  point  one  inch  further  along  is  not  6,  but  9 ;  the 
addition  of  the  second  inch  on  the  scale  not  adding  3  but 
multiplying  by  that  number.  Similarly,  division  is  per- 
formed by  simple  subtraction.  The  application  of  this  prin- 
ciple is  very  wide.  It  is  especially  serviceable  in  working 
out  percentages.  The  slide  rule  is  the  most  convenient  of 
all  instruments  for  working  out  values  where  one  factor  is 


TECHNICAL  IMPROVEMENTS  353 

a  constant,  as  for  instance  in  translating  a  table  of  prices 
from  one  currency  into  another.  Here  only  one  setting  of 
the  machine  is  needed,  the  various  values  being  read  off 
without  further  manipulation  of  the  slide.  In  this  there 
is  an  advantage  even  over  the  more  mechanical  calculating 
machines.  The  chief  objection  is  that  there  is  required 
some  little  practice  in  taking  off  accurate  readings,  and  at 
best  these  are  not  accurate  beyond  the  fifth  significant  fig- 
ure. To  accountants,  who  are  accustomed  to  have  their 
additions  prove  to  the  last  cent,  that  is,  to  show  accuracy 
say  to  the  tenth  figure,  this  seems  at  first  objectionable.  It 
should,  however,  be  borne  in  mind  that  the  original  data 
on  which  calculations  are  made  rarely  are  accurate  beyond 
the  third  figure,  so  that  for  most  purposes  the  slide  rule  ia 
sufficiently  exact. 

Multiplication  being  only  addition  on  a  larger  scale, 
the  key  machines,  designed  primarily  for  addition,  prove 
most  serviceable  for  multiplication,  with  certain  limita- 
tions. If,  for  instance,  123  is  to  be  multiplied  by  321,  it 
can  probably  be  done  more  quickly  on  the  key-adding  ma- 
chine than  on  any  other  mechanical  device.  All  that  is 
necessary  is  to  press  the  keys  indicating  123  once,  then 
moving  the  fingers  one  place  to  the  left  to  press  the  keys 
twice  (that  is,  multiply  1230  by  2,  which  is  equivalent  to 
multiplying  123  by  20),  and  so  on.  This  requires  no  set, 
ting  up  of  a  machine,  and  no  skill  in  reading  results.  The 
drawback  comes  when  the  two  factors  are  large,  as  the  dif- 
ficulty of  manipulating  the  larger  number  of  keys  more 
than  offsets  the  time  required  to  set  up  the  factors  on  a 
calculating  machine  proper. 

Of  the  latter  there  are  several  models,  principally  of 
foreign  manufacture.  In  the  most  advanced  type  the  mul- 
tiplicand is  set  up  by  moving  sliding  indexes,  and  the 
multiplication  is  performed  by  moving  an  indicator  to  each 
of  the  successive  figures  of  the  multiplier  and  turning  the 


354  MODEKN   ACCOUNTING 

handle  once  for  each  digit.  These  machines  are  made  with 
a  capacity  of  eight  digits  in  both  multiplier  and  multipli- 
cand, and  sixteen  figures  in  the  quotient.  After  the  opera- 
tion is  performed  the  dials  exhibit  multiplier  and  mul- 
tiplicand, as  well  as  product— thus  checking  against  errors. 
Division  can  also  be  performed,  but  less  conveniently.  The 
advantage  of  this  type  of  calculating  machine  is  that  it  is 
accurate  to  the  last  figure,  even  when  applied  to  factors 
containing  so  many  digits.  Such  minute  accuracy  is  more 
demanded  in  astronomical  calculations,  for  instance,  than 
in  commercial  accounting,  but  nevertheless  such  machines 
are  being  increasingly  used  in  large  establishments,  such  as 
railroads  and  factories,  principally  for  working  out  per- 
centages. 

The  last  type  of  mechanical  aid  to  be  mentioned  is  the 
mechanical  tabulator.  This  is  a  device  first  introduced  into 
the  United  States  Census  Office  for  tabulating  census  re- 
turns. The  method  used  is  that  of  punching  holes  in  cards, 
the  location  of  the  hole  indicating  certain  statistical  facts, 
as  for  instance  the  number  of  the  job,  the  number  of  the 
workman,  the  terms  on  which  the  work  is  done,  the  time  con- 
sumed, etc.  By  running  the  cards  thus  punched  through 
an  electrical  machine,  a  device,  which  works  by  an  elec- 
trical connection  being  made  wherever  the  hole  is  punched, 
indicates  the  various  charges  made  for  each  job  or  each 
part  of  the  operation.  This  system  has  been  used  by  some 
of  the  railroads,  for  instance,  the  New  York  Central,  and 
by  some  of  the  larger  manufacturing  plants. 

So  far  have  been  described  some  of  the  more  important 
technical  improvements  by  which  the  labor  of  bookkeeping 
has  been  lessened.  Parallel  with  these  improvements,  and 
in  part  logically  implied  in  the  improvements  themselves, 
there  has  been  a  continuous  progress  by  which  accounting 
practice  is  brought  into  closer  coordination  with  the  chang- 
ing economic  conditions.  Indeed,  it  is  no  mere  accident 


TECHNICAL  IMPROVEMENTS  355 

that  systematic  bookkeeping  first  appeared  in  the  Italian 
republics  and  during  the  period  of  their  commercial  su- 
premacy. It  was  not  until  commerce  began  to  assume 
importance  that  systematic  accounting  became  important, 
and  hence  it  naturally  appeared  at  the  time  and  in  the 
place  where  commerce,  in  any  modern  sense,  first  began. 
Some  of  the  minor  technical  improvements  described  in 
this  chapter  are  seen  to  be  conditioned  on  the  change  in 
economic  environment,  as  for  instance  when  the  establish- 
ment of  uniform  currency  made  obsolete  the  forms  which 
were  used  when  the  coinage  was  in  a  state  of  chaos. 

The  greatest  impetus  to  formal  accounting  has,  how- 
ever, been  due  to  more  recent  economic  changes,  two  fac- 
tors of  which,  distinct  yet  closely  connected  being  especially 
important.  These  are  the  introduction  of  machine  produc- 
tion, due  to  the  great  inventions  centering  around  iron 
and  steam,  and  the  development  of  the  corporate  form  of 
industry. 

Taken  together  these  two  factors  have  made  exact  ac- 
counting necessary,  for  three  reasons:  (1)  Ownership  has 
been  separated  to  a  large  extent  from  management  of  in- 
dustry and  there  has  been  an  imperative  need  for  a  scheme 
of  accounting  which  would  disclose  to  the  stockholders  the 
status  of  the  business  entrusted  by  them  to  the  directors; 
(2)  the  large  scale  on  which  business  has  been  conducted 
has  made  accounting  more  complicated  and  hence  has  led 
to  greater  systematization  in  its  methods;  and  (3)  the  use 
of  fixed  capital,  assuming  unheard  of  proportions  since  the 
great  inventions,  has  made  necessary  accounting  methods 
which  would  regard  changes  covering  long  periods  of  time, 
a  marked  contrast  to  the  simple  enterprises  of  the  middle 
age  when  capital  changes  were  disregarded. 

Of  less  importance  may  be  mentioned  the  effect  of  the 
general  growth  of  the  credit  system,  necessitating  a  closer 

scrutiny  of  business  transactions ;  and  the  disappearance  of 
24 


356  MODERN  ACCOUNTING 

the  old  prejudice  against  interest,  with  the  consequent  rec- 
ognition of  interest  calculations  in  inventory  taking  and 
in  cost  accounting. 

The  accounting  problems  of  to-day  as  discussed  in  this 
book  may  be  seen  to  be  closely  dependent  on  the  economic 
changes  mentioned  above.  Most  of  the  debated  questions 
have  had  to  do  with  the  Balance  Sheets  of  corporations, 
and  the  problems  concerning  Capital  Stock.  The  most 
puzzling  question  concerning  Profits  has  related  to  the 
treatment  of  changes  in  the  value  of  invested  capital  and 
the  recognition  of  depreciation  in  machinery.  And  the  new 
problem  of  Cost  Accounting,  the  most  recent  contribution 
to  accounting  literature,  is  entirely  an  outgrowth  of  the 
factory  system  of  production. 

It  is  apparent,  therefore,  that  accounting  never  has  been 
a  stationary  art,  -but  has  changed  with  changing  conditions. 
Altogether  wrong  is  the  quaint  panegyric  of  North,  written 
in  1714: 

"  I  do  not  know,  that  any  Art  practiced  among  Men  is 
come  up  to  a  positive  ne  plus  ultra,  but  that  of  Accompting. 
.  .  .  No  Limit  of  Invention  is  known,  thro'  which  they  [the 
other  Arts]  may  be  improved.  But  the  Art  of  Regular 
Accompting,  or  Book-keeping,  altho'  useful  beyond  any, 
and  of  infinite  Variety,  and  of  which  not  a  few,  able  enough 
in  other  things,  are  utterly  incapable;  yet  in  Rule  and 
Method  is  so  contracted  and  circumscribed,  that  without 
a  Fault,  nothing  can  be  rescinded  from,  or  added  to  it." 

While  accounting  does,  indeed,  rest  on  a  few  simple 
principles  enunciated  while  Columbus  was  still  on  his  voy- 
ages of  discovery,  yet  much  needed  to  be  added  to  the  sim- 
ple rules  laid  down  by  the  "  humble  professor  of  sacred 
theology  "  before  the  art  could  reach  the  present  advanced 
but  still  incomplete  stage  of  Modern  Accounting. 


TECHNICAL  IMPROVEMENTS  357 


BIBLIOGRAPHICAL  NOTE  TO  CHAPTER  XIX 

DICKSEE,  L.  R.  Bookkeeping:  Its  Adaptability  to  the  Require- 
ments of  Every  Class  of  Undertaking.  Article  in  Encyclopaedia 
of  Accounting,  I,  pp.  496-301. 

GAINES,  M.  W.  Tabulating  Machine  Cost  Accounting  for  Factories 
of  Diversified  Product.  Engineering  Magazine,  XXX,  pp. 
364-374. 

KERR,  W.  H.  Calculating  Machines.  Article  in  Encyclopaedia  of 
Accounting,  II,  pp.  1-14. 

RISQUE,  F.  W.  Loose  Leaf  Books  and  Systems  for  General  Busi- 
ness. St.  Louis,  1907. 

Row  FOGO,  J.  History  of  Bookkeeping.  In  "A  History  of  Ac- 
counting and  Accountants,"  edited  by  R.  Brown.  Edinburgh, 
1905. 

SEWARD,  G.  H.  Card  System  and  Mechanical  Aids  in  Accounting. 
Series  of  articles  in  Business  World,  1902-1903. 

SPRAGUE,  C.  E.  The  Philosophy  of  Accounts.  New  York,  1908, 
pp.  82-129. 

SWEETLAND,  C.  A.  Loose  Leaf  Bookkeeping  and  Accounting. 
Fourth  edition.  New  York,  1905. 

THOMPSON,  E.  W.     Bookkeeping  by  Machinery.     New  York,  1906. 

THORNE,  W.  W.     The  Abolition  of  the  Trial  Balance.    Detroit,  1 906. 

Twentieth  Century  Bookkeeping  and  Business  Practice. 

Detroit,  1904.  [The  two  books  last  named  contain  many  prac- 
tical suggestions  as  to  forms  and  methods.] 


INDEX 


Abstainers  &  General  Insurance 
Co.,  in  re,  78. 

Acceptances,  192. 

Accounts,  capital,  144;  differenti- 
ation of,  5,  7,  9;  mixed,  10, 
22;  negative  goods,  14,  24; 
negative  proprietorship,  24, 
27;  positive  and  negative 
items  in,  19;  two  sets  of,  9. 
See,  also,  titles  of  particular 
accounts. 

Accuracy,  55,  83,  170,  306. 

Active,  44. 

Adding  machines,  350. 

Adjustment  accounts,  119,  123. 

Allis-Chalmers  Co.,  136. 

American  bookkeeping,  345. 

American  District  Telegraph  Co., 
48. 

Anticipation  accounts,  119;  rela- 
tion to  depreciation,  123. 

Appraisal,  83.  See,  also,  INVEN- 
TORY. 

Appreciation  of  assets,  223. 

Assets,  appreciation  of,  223;  capi- 
tal, 46;  deferred,  46,  118,  123; 
difficulty  in  distinguishing, 
70;  distribution  of,  in  insol- 
vency, 327,  330;  immaterial 
ch.  vi,  75,  141;  purchased 
with  securities,  79. 

Assets,  wasting,  214;  legal  deci- 
sions, 205;  treatment  in  ac- 
counts, 203. 


Assets  accounts,  19. 

Atchison,  Topeka  &  Santa  Fe*  Ry., 

49,  60,  67,  150,  184,  242. 
Atlantic  Coast  Line,  228. 
Austria,  accounting  rules  in,  92, 

102,  124,  149,  159,  224,  240. 

Babbage,  C.,  293. 

Badham  v.  Williams,  225. 

Balance,  18. 

Balance  account,  41. 

Balance  sheet,  ch.  iii ;  accuracy  in, 
55,  83;  of  Atchison,  Topeka 
&  Santa  Fe  Ry.,  60,  184; 
and  balance  account,  41; 
classes  of  items  in,  50;  double 
account,  48,  184,  202;  English 
form,  42 ;  history  of,  40 ;  mar- 
shaling items  in,  46;  misrep- 
resentations in,  •  55 ;  model 
forms  of,  59-66;  purposes  of, 
54;  subdivisions  in,  45;  and 
trial  balance,  37;  two  sides  of, 
43. 

Balancing,  29. 

Bank  of  England,  84. 

Bank  of  France,  92. 

Barrow  Haematite  Steel  Co.,  in  r#, 
109",  219. 

Belfast  &  Moosehead  Lake  Ry.  Co. 
v.  Belfast,  229,  268. 

Bills  rediscounted,  32. 

Birmingham  Small  Arms  Co., 
255. 


359 


360 


INDEX 


Bolton  v.  Natal  Land  &  Coloniza- 
tion Co.,  86. 

Bond  v.  Barrow  Haematite  Steel 
Co.,  124,  206",  210,  214. 

Bonds,  discount  on,  77,  96,  188; 
formula  for  value  of,  94 ;  pre- 
mium on,  93,  187,  222; repay- 
able at  a  premium,  190;  re- 
purchased, 191;  in  sinking 
fund,  269;  unissued,  190;  val- 
uation of,  90. 

Bookkeeping,  "American,"  345; 
double  entry,  9;  equation,  1, 
28;  single  entry,  7,  10. 

British  East  India  Co.,  41. 

Breaker  and  Chapman,  332°,  339. 

Buildings,  valuation  of,  88. 

Burton,  F.  G.,  307. 

Butler  v.  Ballard,  330'. 

Calculating  machines,  352. 

Caldicott,  O.  H.,  116. 

Camden  v.  Stuart,  115,  157. 

Capital,  chs.  viii-ix;  circulating, 
.  208,  210,  214,  218;  fixed,  116, 
208,  210,  214;  interest  on, 
321;  and  revenue,  72;  wast- 
ing, 206. 

Capital  account,  of  corporation, 
145;  of  individual,  144;  in 
partnership,  144,  317. 

Capital  assets,  46;  appreciation  of, 
223. 

Capital  losses,  199;  in  American 
courts,  211;  booking  of,  218; 
and  dividends,  214-221;  in 
English  courts,  205-211 ;  when 
not  to  be  shown,  221. 

Capital  stock,  canceled,  151;  in 
consolidations,  179;  discount 
on,  158;  donated,  176;  issued 
for  property,  79,  161-171; 


market  value  of,  163;  nomi- 
nal value  of,  165;  premium 
on,  155,  221,  222;  reacquired, 
151;  reduction  of,  159;  sale 
below  par,  157;  subscriptions 
to,  147;  uncalled  subscriptions 
to,  153;  unissued,  147. 

Capital  stock  issued  below  par, 
157,  161 ;  in  American  balance 
sheets,  168;  booking  of,  158, 
167;  in  England,  158;  legal 
decisions,  157,  165;  for  prop- 
erty, 163;  unnecessary,  163. 

Cash  account,  5,  19";  position  in 
balance  sheet,  46. 

Cash  book,  343,  346. 

Chemical  National  Bank,  63,  64, 
68,  240. 

Chicago  &  Alton  Ry.,  46. 

Chicago  &  Northwestern  Ry.,  32", 
253,  266;  sinking  fund,  263, 
266,  268;  treasury  stock  of, 
152;  unissued  bonds  of,  191. 

Chicago  City  Railway,  290. 

Chicago,  Rock  Island  &  Pacific 
Ry.,  262. 

Child,  P.,  116. 

Chronological  record,  341-345. 

Church,  A.  H.,  300,  302,  303,  305. 

Circulating  assets,  81,  210. 

Circulating  capital,  208,  214,  218. 

Clearwater  v.  Meredith,  216. 

Coats,  J.  &  P.,  55. 

Colorado  Fuel  &  Iron  Co.,  221. 

Columbia  Straw  Paper  Co.,  112, 
170. 

Columnar  journal  cash  book,  344. 

Columnar  records,  343,  345. 

Companies  Acts,  Great  Britain, 
42, 55, 66, 68, 77, 153, 158, 171, 
248..  335,  339;  Quebec,  149. 

Connecticut  corporation  law,  80. 


INDEX 


361 


Consolidations,  179. 

Construction  account,  72,  75,  77, 
78,  118,  189. 

Contingent  liabilities,  32,  192. 

Controlling  account,  119. 

Conville  v.  Shook,  125. 

Cooper,  E.,  116,  228. 

Corporate  organization,  effect  on 
accounting,  355. 

Cony  v.  Londonderry  &  Ennis- 
killen  Ry.,  228. 

Cost,  factory,  296;  prime,  296; 
total,  296. 

Cost  accounts,  ch.  xvi,  293;  ac- 
curacy of,  306;  application  of 
results,  307;  cost  ledger,  313; 
expense  of,  306;  in  Govern- 
ment Printing  Office,  306; 
materials,  309;  purpose  of, 
293;  records  needed,  309;  req- 
uisitions, 312;  stores  record, 
311;  technic  of,  308;  terminol- 
ogy, 295;  wages,  309. 

Cost  price,  90;  actual  or  construc- 
tive, 103;  as  basis  of  valua- 
tion, 75,  102,  108;  what 
constitutes,  75;  of  property 
purchased  with  securities,  79. 

Getting  v.  New  York  &  New  Eng- 
land R.R.  Co.,  213°. 

Courts,  attitude  regarding  over- 
valuation, 162;  regarding 
profits,  231. 

Cox  v.  Edinburgh  &  District 
Tramways  Co.,  73. 

Credit,  19,  20. 

Credit  system,  effect  of  account- 
ing, 355. 

Crichton's  Oil  Co.,  in  re,  209. 

Davis  v.  Flagstaff  Silver  Mining 
Co.,  229. 


Davison  v.  Gillies,  124,  201'. 

Dawson,  S.  S.,  248. 

Day  book,  343. 

Debit,  19,  20. 

Debits  and  credits,  equation  of, 
23,  28;  personification  of,  21; 
scheme  of,  27. 

Debts,  13,  24,  101;  bad  and  doubt- 
ful, 99,  238;  paid  out  of  re- 
serve, 258;  reserve  for  doubt- 
ful, 100;  unpaid,  and  profits, 
228.  See  also  LIABILITIES. 

Deferred  assets,  118,  123. 

Deficiency  account,  126,  335,  338. 

Delkredere  account,  68. 

Dennis,  W.  H.,  339.  - 

Depreciation,  ch.  vii,  83;  by  Amer- 
ican corporations,  290;  an- 
nuity method,  131;  booking 
of,  67,  126;  comparison  of 
methods,  133;  economic  sig- 
nificance, 121;  excessive,  137; 
as  fixed  charge,  291;  formulas 
for,  128,  129,  132;  of  imma- 
terial assets,  141;  Interstate 
Commerce  Commission  on, 
125,  127,  135,  142,  290;  irreg- 
ular, 136;  legal  provisions, 
124,  134;  methods  of  appor- 
tionment, 128;  and  net  in- 
come, 290;  percentage  of  cost, 
128;  percentage  of  diminish- 
ing value,  129;  where  no  prof- 
its, 136;  prior  to  profits,  121; 
in  profit  and  loss  account,  289; 
rates  of,  141;  relation  to  an- 
ticipation accounts,  123;  re- 
lation to  total  cost,  134;  and 
replacement,  137;  and  reserve 
for  insurance,  260;  and  sink- 
ing fund,  272;  in  addition  to 
wear  and  tear,  140. 


362 


INDEX 


Depreciation  account,  51. 

Depreciation  fund,  238. 

Dickinson,  A.  L.,  171,  249,  279. 

Dicksee,  L.  R.,  on  balance  sheet, 
55;  on  cost  accounts,  308;  on 
depreciation,  134,  142;  on 
distribution  of  assets,  332°; 
on  Garner  v.  Murray,  330"; 
on  good  will,  113,  116,  117; 
on  manufacturing  account, 
286;  on  partnerships,  321;  on 
reserve  funds,  248,  249;  on 
sinking  funds,  270. 

Discount,  on  bonds,  77,  96,  188; 
on  capital  stock,  158,  167; 
due  to  deficient  credit,  189; 
on  mercantile  credits,  98;  on 
sales,  288;  trade,  288. 

Dividends,  from  borrowed  funds, 
229;  during  construction,  77; 
when  loss  of  capital,  214; 
when  loss  of  fixed  capital,  217; 
not  paid  in  cash,  228;  on  pre- 
ferred stock,  193;  stock,  172; 
unpaid,  193. 

Donald  v.  American  Smelting  & 
Refining  Co.,  161,  166. 

Donated  stock,  176. 

Double-account  balance  sheet,  48, 
67,  184,  202. 

Double  entry  bookkeeping,  chs. 
i-ii,  1,  9,  15;  imperfections 
of,  30. 

Doubtful  debts,  100. 

Douglass  v.  Ireland,  178. 

Dovey  v.  Cory,  201m,  209,  210. 

Dupin,  227. 

Dutch  East  India  Co.,  228. 

Eddis,  W.  C.,  250. 
Edgerton  v.  Electric  Improvement 
Co..  166. 


Emery  v.  Wilson,  125*. 

Encyclopaedia  of  Accounting,  288. 

Equation,  bookkeeping,  1,  28. 

Excelsior  Water  &  Mining  Co.  v. 
Pierce,  206",  213",  230/268. 

Exchange  transactions,  2. 

Expense  account,  24,  27. 

Expenses  of  experimentation,  77. 

Eyster  v.  Centennial  Board  of  Fi- 
nance, 211,  226. 

Factory  cost,  296. 

Factory  expenses,   indirect,   297,  - 

304. 

Fairchild,  C.  S.,  114. 
First  National  Bank,  Chicago,  241. 
First  National  Bank,  New  York, 

253. 

Fixed  assets,  81. 

Fixed  capital,  116,  207,  210,  217. 
Fluctuations,  82. 
Formulas,  for    depreciation,    128, 

129,    132;  for  sinking  fund, 

271. 
France,   accounting  rules  in,   41, 

124,  151,  152,  154,  240,  349; 

Bank  of,  92. 
Franchise  account,  169. 
Freight  charges,  102. 
Fund  assets,  249. 

Garcke  and  Fells,  116. 

Garner  v.  Murray,  329. 

General  establishment  charges, 
305. 

Germany,  accounting  practice  in, 
55,  65,  68,  79,  84,  134,  152, 
164,  178,  237. 

Germany,  legal  provision  in,  on 
balance  sheet,  41,  55;  on  com- 
pulsory reserves,  240,  242 ;  on 
depreciation,  124,  127,  134, 


INDEX 


363 


136;  on  interest,  77,  87;  on 
inventory,  92,  102;  on  pre- 
mium on  stock,  155,  234,  240; 
on  repurchased  stock,  151 ; 
on  uncalled  subscriptions,  154; 
on  unrealized  profits,  224; 
on  unsubscribed  capital,  149. 

Goethe,  J.  W.,  30. 

Going  concern,  81,  91,  101. 

Goods,  1. 

Goods  accounts,  7. 

Goodwill,  an  asset,  75;  in  the  bal- 
ance sheet,  117;  basis  of,  110; 
definition  of,  107;  determina- 
tion of  cost,  109;  Dicksee's 
rule  for  valuing,  113;  duration 
of  surplus,  112;  fictitious,  115, 
169;  instances  of,  110,  111, 
112,  113,  117;  method  of  cap- 
italizing, 111;  in  partnership, 
318;  period  for  averaging  sur- 
plus, 111;  rate  of  capitalizing, 
113;  transferability  of,  112; 
value  limited  to  cost,  108; 
writing  off  of,  116. 

Government  Printing  Office,  306. 

Gratz  v.  Redd,  76,  223. 

Greendlinger,  L.,  339. 

Greene,  T.  L.,  172,  189. 

Gross  trading  profits,  287. 

Gunnell  v.  Bird,  330°. 

Guthrie,  E.,  108,  116. 

Handley  v.  Stutz,  157,  165. 
Hoare  &  Co.,  in  re,  209,  221,  234, 

248. 

Hubbard  v.  Weare,  73,  213'. 
Huffcut,  E.  W.,  157. 
Hugli,  F.,  22. 

Illinois  Central  Railway,  101,  184, 
249,  288. 


Immaterial  assets,  ch.  vi,  75; 
amortization  of,  141. 

Income,  net,  267,  290;  in  probate 
law,  201. 

Income  account,  195,  280,  281. 

Indirect  factory  expenses,  297, 
304. 

Indorsements,  192. 

Innes  &  Co.,  in  re,  178. 

Insolvency,  distribution  of  assets 
in,  327,  330;  statement  of  af- 
fairs in,  335. 

Insolvent  partners,  claims  against, 
328, 

Insurance,  reserve  for,  259. 

Intere$t,  accrued,  97;  adjustments, 
321,  324;  on  debts,  186;  dur- 
ing construction,  76;  on  ex- 
cess capital,  324;  paid  in 
advance,  118;  on  partners' 
capital,  321;  on  purchase 
mortgage,  86;  on  sinking 
fund  investments,  265,  269. 

International  Mercantile  Marine 
Co.,  290. 

Interstate  Commerce  Commission, 
on  balance  sheet,  41,  59;  on 
construction  account,  74,  79, 
254;  on  depreciation,  125, 
127,  134,  135,  136,  142,  290: 
on  discount,  77,  190;  on  in- 
come account,  282;  on  secret 
reserves,  254;  on  taxes,  289. 

Inventory,  13,  23,  31;  items  to1  be 
included,  75;  problems  of,  74. 

Investments,  fluctuations  in,  90; 
interest  accrued,  97;  premium 
on,  93;  as  stock  in  trade,  92; 
valuation  of,  90,  92. 

James,  A.  A.,  116. 
Jaudon,  W.  C.,  330'. 


364 


INDEX 


Jones,  T.,  9,  21. 
Jones  v.  Davis,  226. 
Journal,  342. 
Journal-cash  book,  343. 

Keister,  D.  A.,  169,  249. 
Kingston  Cotton  Mill  Co.,  in  re, 

208. 
Kirkmann,  M.  M.,  267. 

Lackawanna  Steel  Co.,  188. 

Land,  valuation  of,  86. 

Langstroth,  J.  A.,  349. 

Leake,  P.  D.,  136. 

Ledger,  17,  341,  347-350;  cost, 
313;  loose  leaf,  348. 

Lee  v.  Neuchatel  Asphalte  Co., 
205,  213,  214,  223. 

Liabilities,  ch.  x;  in  balance  sheet, 
184;  capital,  46;  classification 
of,  186;  contingent,  32,  192; 
current,  46;  marshaling  of, 
47;  as  negative  assets,  184;  in 
statement  of  affairs,  338.  See 
also  DEBTS. 

Liquidation,  distribution  of  as- 
sets in,  327,  330. 

Liquidation  value,  80. 

Lisle,  G.,  42,  275,  278,  287,  288, 
339. 

Lizet,  A.,  342. 

London  &  Westminster  Bank,  62. 

Losses,  of  circulating  capital,  218; 
of  fixed  capital,  207,  214; 
prior,  208;  shown  in  balance 
sheet,  120. 

Louisville  &  Nashville  R.R.,  264. 

Lubbock  v.  British  Bank,  etc.,  223. 

Machine  production,  effect  on  ac- 
counting, 355. 

Machine  rate,  297,  299;  improved, 
300. 


Machinery,  valuation  of,  89. 
Mackintosh  v.  Flint  &  Pere  Mar- 

quette  Ry.,  73,  124. 
Main  v.  Mills,  212. 
Maine  Savings  Bank  law,  93. 
Manufactured  goods,  valuation  of, 

104,  284,  286. 
Manufacturing  account,  274,  279, 

284,  289. 

Manufacturing  profits,  285. 
Market  price,  90,  102. 
Massachusetts   business   corpora- 
tion law,  41,  171. 
Materials,  309. 
Mechanical  devices,  350. 
Memorial,  342. 
Memoriter  accounts,  68. 
Mercantile  credits,  98. 
Merchandise,   valuation  of,   101- 

105. 

Meserve  v.  Andrews,  102,  224. 
Mills  v.  Northern  Ry.  of  Buenos 

Ayres  Co.,  229,  230". 
Mitchell,  W.,  346. 
Mixed  accounts,  10,  22. 
Mixed  transactions,  2,  10. 
Mobile,   etc.,    Ry.   v.  Tennessee, 

229. 

More,  F.,  114. 
Moseley    v.    Koffyfontein    Mines. 

167. 
Moxey,  E.  P.,  Jr.,  279". 

National  Bank  of  Wales,  in  re, 

20  ln,  208,  209. 
Negative  goods,  14,  184;  accounts, 

24. 
Negative  proprietorship  accounts. 

24,  27. 
Newton    v.    Birmingham    Small 

Arms  Co.,  84,  255. 
Nisbet,  A.  G.,  304. 


INDEX 


365 


North,  R.,  356. 
Nowell  v.  Nowell,  328. 

Oakley  v.  Cokalete,  330'. 

Ooregum  Gold  Mining  Co.,  etc.,  v. 
Roper,  158. 

Operating  expenses,  72,  288. 

Organization  expenses,  76,  78. 

Overvaluation,  162,  170. 

Oxford  Benefit  Building  &  Invest- 
ment Co.,  in  re,  100. 

Paciolo,  L.,  1,  40,  341,  342,  345, 
346. 

Palmer,  F.  B.,  206,  209",  218,  220. 

Partnership,  ch.  xvii;  admission 
to,  316;  capital  account,  316; 
claims  against  insolvent  part- 
ner, 328;  distribution  of  as- 
sets, 327;  formation  of,  316; 
goodwill,  318;  interest  on  cap- 
ital, 321;  interest  on  excess 
capital,  324;  problems,  316; 
purchase  of  interest,  320; 
share  in,  318. 

Passive,  44. 

Patents,  77,  110,  117. 

Patterns,  89,  306. 

Pennsylvania  R.R.  Co.,  254, 
267. 

Pensions,  provisions  for,  194. 

People  v.  San  Francisco  Savings 
Union,  226. 

Personification  theory,  21. 

Pixley,  F.  W.,  86,  116,  193,  214, 
247,  248,  249. 

Platt,  A.  G.,  339. 

Premium,  on  bonds,  93,  187,  222; 
on  capital  stock,  155,  221, 
234;  fictitious,  156;  on  for- 
feited stock,  222;  redemption 
at  a,  190. 


Price,  cost,  75,  79,  90,  103,  108; 
market,  90,  102;  selling,  288, 
296. 

Prime  cost,  296. 

Profit  and  loss  account,  ch.  xv, 
195;  and  assets,  197;  and 
capital  losses,  199;  deprecia- 
tion shown  in,  289;  forms,  276, 
278,  282;  problems  of,  198; 
purpose,  196;  subdivisions, 

•:  277,  282;  and  taxes,  288; 
variations  in,  282. 

Profit  and  loss  appropriation  ac- 
count, 277. 

Profits,  chs.  xi-xii;  available  for 
dividends,  226;  in  balance 
sheet,  54;  in  cash,  224;  and 
debts,  228;  gross  trading,  287; 
and  loss  of  capital,  202;  and 
loss  of  fixed  capital,  207;  net, 
203,  212,  275;  and  previous 
losses,  208;  undivided,  237; 
unrealized,  224;  and  wasting 
assets,  203. 

Property  purchased  with  stock, 
79,  161. 

Proprietorship,  1. 

Proprietorship  accounts,  9,  19. 

Proprietorship  transactions,  2-4. 

Providence  Rubber  Co.  v.  Good- 
year, 100,  104. 

Quebec  Company  Act,  149. 
Quoted  price,  90,  102. 

Raymond  v.  Putnam,  329. 
Reagan  v.  Farmers'  Loan  &  Trust 

Co.,  226. 
Receipts,  confounded  with  profits, 

226. 
Redlands  Water  Co.  v.  Redlands, 

125V 


366 


INDEX 


Rehm,  H.,  33,  68,  154,  185,  189, 
247,  250. 

Renewal  fund,  241. 

Replacement,  137. 

Republic  Iron  &  Steel  Co.,  290. 

Requisitions,  312. 

Reserve,  ch.  xiii,  237;  of  Atchison, 
Topeka  &  Santa  Fe"  Ry.,  242; 
for  bad  and  doubtful  debts, 
100,  238;  banking,  250;  com- 
pulsory, 239;  for  contingen- 
cies, 240;  disbursement  of, 
255;  distinguished  from  re- 
serve fund,  249;  for  equalizing 
dividends,  241;  for  exten- 
sions, 238;  general,  242;  for 
increasing  capital,  239;  for 
insurance,  259;  of  insurance 
companies,  251;  open,  250; 
for  paying  debts,  258;  pur- 
poses of,  239;  secret,  137,  252, 
255,  257;  source  of,  243;  spe- 
cial, 242;  specially  covered, 
244;  specific,  237;  of  United 
States  Steel  Corporation, 
242. 

Reserve  fund,  237;  distinguished 
from  reserve,  249. 

Rest,  237. 

Retired  stock,  159. 

Revaluation,  principles  of,  80. 

Revenue  account,  195. 

Revenue  expenditure,  72. 

Richardson  v.  Buhl,  125,  213". 

Robinson  v.  Ashton,  318. 

Row-Fogo,  J.,  342. 

Saint  Ambrose,  Bank  of,  240. 
San  Diego  Water  Co.  v.  San  Diego, 

125". 

Schaer,  J.  F.,  22. 
Schulte  v.  Anderson,  330". 


Schurtz,  G.  N.,  41. 

Schuster,  E.,  177. 

Secret  reserves,  137,  252,  255,  257. 

See  v.  Heppenheimer,  154,  157, 
166,  172. 

See-Han  dlungs-Gesellschaft,  228. 

Simon,  H.  V.,  151,  248*. 

Single  entry,  7,  10. 

Sinking  fund,  ch.  xiv;  of  Chicago 
&  Northwestern  Ry.,  263, 
266;  of  Chicago,  Rock  Island 
&  Pacific  Ry.,  262;  compari- 
son of  different  methods,  265; 
definition,  261;  and  deprecia- 
tion, 272;  as  a  fixed  charge, 
266;  formula  for,  271 ;  interest 
on,  265,  269;  investment  of, 
263;  of  Louisville  &  Nashville 
Ry.,  264;  methods  of  booking, 
261;  and  net  income,  267; 
payment  of  bonds  from,  269', 
of  Pennsylvania  R.R.  Co., 
267;  of  United  States  Steel 
Corporation,  67,  264. 

Sinking  fund  accretions,  269. 

Slay  den  v.  Coal  Co.,  226. 

Slide  rule,  352. 

Smith,  A.,  210. 

Smith,  O.,  304. 

Southern  Railway,  288. 

Speer  v.  Bordeleau,  178. 

Sprague,  C.  E.,  1",  22,  45. 

Statement  of  affairs,  335. 

Stewart  v.  St.  Louis,  etc.,  R.R., 
162. 

Stock  dividends,  172. 

Stock  watering,  79,  171. 

Stores  record,  311. 

Stringer's  case,  225. 

Subscriptions  to  capital  stock,  147, 
153. 

Supplementary  rate,  301,  302. 


INDEX 


367 


Surplus,  155,  233,  234,  235,  237, 
240.     See  also  RESERVE. 

Table  A,  Companies  Act,  66,  68, 

153,  248. 

Tabulator,  mechanical,  354. 
Taxes,  288. 
Terminology,  56. 
Tiffany,  H.  L.,  130,  142. 
Tipson,  F.  S.,  339. 
Tools,  valuation  of,  89. 
Total  cost,  296. 

Towers  v.  African  Tug  Co.,  210. 
Trade  discounts,  288. 
Trading  account,  133,  274;  forms 

of,  276,  278;  selling  price  in, 

288;  trading  expenses  in,  287; 

valuation    of    manufactured 

goods  in,  284. 
Trading  expenses,  287. 
Trading  profits,  285. 
Treasury  stock,  150,  152. 
Trial  balance,  35. 
Tutt  v.  Land,  125". 

Undervaluation,  84. 

Undivided  profits,  237. 

Union  Pacific  R.R.  Co.  v.  United 

States,  85. 
United  Railways  Investment  Co., 

120. 
United   States   Shipbuilding   Co., 

170. 
United  States  Steel  Corporation, 

Form  29,  67,  159,  242,  249, 

264 


United  States  v.  Kansas  Pacific 
Ry.  Co.,  125. 

United  Verde  Copper  Co.,  v.  Rob- 
erts, 206",  213m. 

Valuation,  principles  of,  80. 
Valuation  accounts,  50,  53,  57,  70, 

235. 

Van  de  Linde,  G.,  32. 
Verner  v.  General  &  Commercial 

Trust,    92,    207,     210,     218, 

229. 

Wages,  309. 

Walton,  S.,  178. 

Warren  v.  King,  229. 

Washburn  v.  National  Wall  Paper 
Co.,  107. 

Wasting  assets,  203,  205,  214. 

Watered  stock,  171. 

Wells-Fargo  Express  Co.,  240. 

Welton,  T.  A.,  116. 

Wetherbee  v.  Baker,  166. 

Whatley,  G.  E.  S.,  248. 

Whitcomb  v.  Converse,  329. 

Whitmore,  J.,  304,  307. 

Whittaker  v.  Amwell  National 
Bank,  89,  125. 

Williams  v.  Western  Union  Tele- 
graph Co.,  175,  230. 

Wilmer  v.  McNamara,  116,  206° 
208. 

Woelfel  v.  Thompson,  329. 

Woodlock,  T.  F.,  73. 

Working  capital.  179. 


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